Decomposing LIBOR in Transition: Evidence from the Futures Markets

TL;DR

This paper models the relationships between LIBOR, SOFR, and other rates during the transition period, decomposing spreads to understand the impact of credit and liquidity risks, especially during COVID-19.

Contribution

It introduces a joint modeling framework that endogenously decomposes benchmark rate spreads, providing new insights into the drivers of LIBOR-OIS spread during transition.

Findings

LIBOR-OIS spread spike during COVID-19 was mainly due to credit risk.

On average, credit and liquidity risks contribute equally to the spread.

The model captures the dynamics of multiple benchmark rates during transition.

Abstract

Applying historical data from the USD LIBOR transition period, we estimate a joint model for SOFR, Fed Funds, and Eurodollar futures rates as well as spot USD LIBOR and term repo rates. The framework endogenously models basis spreads between each of the benchmark rates and allows for the decomposition of spreads. Modelling the LIBOR-OIS spread as credit and funding-liquidity roll-over risk, we find that the spike in the LIBOR-OIS spread during the onset of COVID-19 was mainly due to credit risk, while on average credit and funding-liquidity risk contribute equally to the spread.