Interest Rates

There are different types of interest rates that are vital for derivatives desk. These are used in derivative valuations, cash flow calculations and projections and beyond.

Treasury Rates

Every government borrows the money in their own currency at some rate by issuing Treasury notes or bonds. This rate is known as a Treasury rate of that country. This is usually known as a risk-free rate of issuing country.

Treasury rates are used to price Treasury instruments.

LIBOR / LIBID

LIBOR stands for London Interbank Offer Rate. This is regarded as better indicator as risk-free rate than Treasury rates. LIBOR is quoted by AA rated bank and other financial institutions. A LIBOR quote from a bank is the rate of interest at which the bank is prepared to lend large amounts of money. Borrower must be AA rated to avail this rate.

There are two reason why LIBOR is highly regarded. First, AA rated institutions have very small chance of defaulting on LIBOR loan. Second so risk-free Treasure rates are artificially kept low due to tax and regulatory reasons.

In derivatives world (especially OTC market), risk-free rates are usually LIBOR rates (or derived from LIBOR, swap rates etc).

In contract, LIBID is the London Interbank Bid Rate. This is the rate at which bank is prepared to take deposits (borrow).

LIBOR is higher than LIBID, the spread is usually much smaller.

LIBOR is quoted in all popular currencies. LIBOR rates are totally market driven and not controlled by any independent body or the government.

Repo Rate

Repo rates are usually overnight rates. Repo rate is the rate derived from repurchase agreements. Repurchase agreement is the type of contract, where dealer sells the securities at some price now and buys back later at slightly higher price. The price difference is the rate of return to the lender from the agreement. The rate of return is the Repo rate.

ZERO Rate

The n-year zero rate means, the rate of interest earned on an investment invested today and helf for n-years without any coupon payments in between. It is also known as n-year Zero Coupon Interest Rate, n-year Spot rate or n-year zero.

Forward Rate

Forward rate is interest rate to borrow/lend in the future some time. For example, 1 year forward rate starting 6 months from now. That means the loan starts after six months from now and for a period of 1 year from then.

Forward rates are derived based current rates of different maturities.

Interest Rate Curve or Term Structure

Interest Rates for different maturities form a curve that is know as interest rate curve. For example, zero rate curve

Maturity Rate
1d 0.9
1w 1.0
1m 1.1
3m 1.3
6m 1.5
1y 2.0
5y 3.0
10y 3.5
15y 4.3
30y 5.1

All types of interest rates curves are captured/computed and stored. These curves play very important role in derivatives world. So, it will become key responsibility of systems team to load and maintain this data quite accurately.

(To learn more about Curves, refer the post ‘Curves, Curves and Curves’)

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