Rate curves

Today’s post is about rate curves, what they are, their purposes and where things are at the moment (Of writing this post)

  • What’s a rate curve?

The point of a rate curve is to produce discount factors (or discounting rates) in order to discount cash flows, estimate rates or capitalize a cash flow. In school, you tend to consider that there is an unique flat rate for all your discounting needs but in fact the rate is not constant over time and tend (it’s not a guarantee at all) to increase over time as your risk increases.

  • What’s inside a rate curve?

The main problem is that you need to find rates which are the best representation of where the risk free rates are sitting. So you’ll want to use the most liquid interbank instruments. For a standard curve, you’re usually looking at deposits on the short term, rate futures on the mid term and swaps on the longer term.

  • Is there more than one curve?

Sadly, yes. When I started people were using only one curve making risk management a hell lot easier. Then the cross currency basis curves appear. The expectation was that risk  is different for transactions which used more than a currency (FX deals and currency swaps for instance). So one would build a curve with liquid cross currency deals (today’s trend is swap points up to 1y, 18m and currency swaps on the longer run).
But it did not end there! Afterwards estimation curves were introduced as forecasting a 3m rate, 6m rate and 1m rate on the same curve was not returning correct results. Depending on the curve, the instruments are different but usually deposit for the first pillar as it also anchors properly the fixing rate for the day once published, futures or FRAs if available/liquid and basis swaps (also when available/liquid).
Finally, the curve that is maybe the most popular now: Overnight curve (Also called OIS Curve (for Overnight Index Swap). It is used for forecasting the overnight rate but also discounting many transactions (normally all collateralized ones, but I’ll detail that in another post). OIS curve is built using a depo for the O/N pillar and then either futures when available/liquid and OIS for the longer run.

While all these curves return a price which tends to be much closer to the market, they also make risk management a lot more complex especially as curves are related. So non rates traders are forced into this world and need to hedge their basis risk where before they were just looking at a single IR risk figure per currency.

Feel free to discuss further in the comments below or the forum, but it is a vast subject and worth actually multiple posts rather than just one.