Term Rates, Multicurve Term Structures and Overnight Rate Benchmarks: A Roll-Over Risk Approach

Modelling the risk that a financial institution may not be able to roll over short-term borrowing at the market reference rate, we derive the dynamics of (interbank) reference term rates (e.g., LIBOR) and their spread vis-a`-vis benchmarks based on overnight reference rates, e.g., rates implied by overnight index swaps (OIS). This is particularly relevant to the current debate around the transition of replacing the former by the latter. The model endogenously generates different interest rate term structures for each tenor, that is, for each different choice of the length of the interest rate accrual period, be it overnight (e.g., OIS), three–month LIBOR, six–month LIBOR, etc. We show that it can be calibrated simultaneously to available market instruments at a particular point in time, and the model interpolates the market for basis spreads of different tenors well, giving confidence for the use of the model to price bespoke tenors relative to the market.