HullOFOD9eSolutionsCh09.pdf

Chapter 9 OIS Discounting, Credit Issues, and Funding Costs Practice Questions Problem 9.1. Explain what is meant by (a) the 3-month LIBOR rate and (b) the 3-month OIS rate. Which is higher? Why? The 3-month LIBOR rate is the rate at which a AA-rated bank can borrow from other banks. (Banks report these rates to the British Bankers Association at 11am each day.) The three-month OIS rate is the rate that can be swapped for the geometric average of the effective overnight federal funds rate. The 3-month LIBOR rate is higher. The difference is shown in Figure 9.1. The difference arises from the fact that there is more risk in making a single three-month loan to a creditworthy bank than a series of overnight loans to creditworthy banks. If a bank’s creditworthiness declines during the 3 months, it will no longer be able to borrow in overnight markets, but the 3 month loan will still be outstanding. Problem 9.2. ‘‘When banks become reluctant to lend to each other the 3-month LIBOR-OIS spread increases.’’ Explain this statement. As explained in the answer to the previous question, the LIBOR-OIS spread depends on the perceived difference between the riskiness of a three-month loan to a bank and the riskiness of a series of overnight loans to the same bank. This difference increases when market conditions are such that banks are reluctant to lend to each other. Problem 9.3. Suppose that in Example 9.2 where LIBOR discounting is used the 3-year LIBOR-for-fixed swap rate with annual payments is 7% (annually compounded). What is the 3-year LIBOR/swap zero rate? What is the LIBOR forward rate for the period between 2 and 3 years? A three year bond paying 7% is worth par. Hence, the three-year LIBOR/swap zero rate is given by R where 100 )1( 107 0603.1 7 05.1 7 32 ? ? ?? R showing that the three-year LIBOR/swap zero rate is 7.097% The LIBOR forward rate for the third year is ??1 00603.1 07097.1 2 3 9.263% Problem 9.4. Sup