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28.07.2009

Interest Rates and The Credit Crunch: New Formulas and Market Models

A February 09 paper by Fabio Mercurio has been referred to us by Gerry Salkin at Imperial College's Centre for Quantitative Finance.

Its relevance to Liquidity can be summarised in this quote from the paper:

"The liquidity crisis widened the basis, so that market rates that were consistent with each other suddenly
revealed a degree of incompatibility that worsened as time passed by. For instance, the
forward rates implied by two consecutive deposits became di erent than the quoted FRA
rates or the forward rates implied by OIS (EONIA) quotes. Remarkably, this divergence
in values does not create arbitrage opportunities when credit or liquidity issues are taken
into account. As an example, a swap rate based on semiannual payments of the six-month
LIBOR rate can be di erent (and higher) than the same-maturity swap rate based on
quarterly payments of the three-month LIBOR rate."

The subject of EONIA has been referred to earlier in the Risk Liquidity news sections and is of huge importatance in the pricing of interest and of course liquidity

We will also bring Gerry Salkin's paper shortly - if you would like an early look, please contact laura.gustar@pelican-consulting.co.uk

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