Comparison of One-Year Swap vs One-Year Libor

Thomas S. Coleman

March 9, 2017

Let me weigh in on this.

This is a long post but I think there are four the issues and they can be easily summarized:

1. Different quotation bases

2. Single vs dual (OIS) curve

3. Futures for building the curve and illiquidity of 1 year libor

4. 3-month vs 6-month libor basis

Issues (1) and (2) don’t matter - they are small numerically
Issue (4) is not directly relevant to the USSW1 but should be mentioned.
Issue (3) is the key issue. Eurodollar futures are the relevant securities for pricing and hedging swaps.
They are cheap and easy to transact. The 12-month libor deposit is illiquid and expensive and it is
just not the relevant security. You might think you could arbitrage 12-month libor deposits against
swaps or futures but as a practical matter it will be too expensive. The 6-month and 12-month libor
are not really relevant.
Here are the issues in order:

1) Quotation bases:

US Libor is quoted on a money-market basis, USSW1 on a 30/360 semi-annual bond basis. Compar-
ing USSW1=1.2965%sab vs US0012M=1.74428%amm is like comparing 20deg fahrenheit vs 25deg
celsius - it is just the wrong way to do the comparison. Here is a table with all rates converted to
semi-annual bond basis. (I am also attaching a .pdf - go to that to see the tables and figures drawn
properly in case the formatting here does not work. )

Table 1: Instrument Quotes on Various Bases

qmm amm sab
USSW1 1.2965%
US0006M 1.36239% 1.3813%
US0012M 1.74428% 1.7607%
Quotes from Bloomberg for 23-feb-2017, US dollar one-year swap (semi
30/360) and US dollar libor (A/360 money-market). Original quotes
italic / underlined. For details on quotation bases and conversion be-
tween them see my paper “A Practical Guide to Bonds and Swaps” on
ResearchGate or SSRN: https://papers.ssrn.com/abstract=2279377.

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You can find details about the definitions of quotation bases (money market versus bond basis) in my
paper “A Practical Guide to Bonds and Swaps” on ResearchGate or SSRN: https://papers.ssrn.com/abstract=2279377.
(Apologies for quoting myself, but that is the easiest place for me to point you to.)
When we convert all the quotes to the same basis (semi-bond in this case) there is still a difference
between USSW1 and US0012M. Even though expressing security quotes on the same basis is really
important, the differences between money-market and semi-bond basis here are not big - this is not
the reason for the discrepancy between USSW1 and US0012M.

2) Single versus Dual (OIS) Curve Fitting

Originally swaps were priced with a single (libor) curve for projecting resets and discounting cash
flows. As one of the commenters highlighted, over the past few years the market has moved to
a methodology that uses the libor curve to project cash flows and the OIS (Fed Funds) curve for
discounting future cash flows.
For a single curve methodology the statement by Masahiro Fujimoto is correct (“the present value
of floating side is always par (of course, adding the fictitious final exchange of the notional amount).
Therefore the present value is determined by the present value of fix side (of course, again adding
the fictitious final exchange of the notional amount).”)
For a dual curve methodology this statement will not be correct, because the floating libor cash
flows will be discounted at a rate different from libor and thus will not be par. There are ways
to modify this approach. (Again, apologies for quoting myself, but see “Swap Valuation with Dual
Curves” here in ResearchGate.)
Nonetheless, the differences in curve methodology are not the reason for the differences between
USSW1 and US0012M. The important point here is that valuation for single-curve and dual-curve
methodologies give virtually the same answer for at-market (zero-PV) swaps. This means that the
at-market swap rate (USSW1 in this example) obtained by building a curve using a single libor
curve will be almost identical to the at-market rate using a dual (libor / OIS) curve.
To see this, consider the following picture (go to the .pdf if you cannot see the picture), which shows
the cash flows for a one-year swap with fixed rate X. (The 0.688764 is the projected 6-month libor
payment = 1.36239 * 182/360; 182 days from the Monday 27-feb-17 settle to the Monday 28-aug-17
payment date. The 1.0724 is the projected forward payment obtained from (1+.0174428*365/360)
/ (1.00688764)).
The job of finding the at-market swap rate is to solve for X such that
0 = PV(CF=(X/2-0.688746); t=182 days; Rate=Y) + PV(CF=(X/2-1.0724); t=365 days; Rate=Y)

For single-curve methodology we discount at the rate X, so Y=X. (Actually we need to discount at
an upward-sloping curve rather than flat rate, but the idea is the same and the answer is virtually the
same.) In this case the answer is X=1.7595%. For dual-curve (OIS), we discount at the rate Y=OIS.
With OIS rate 1.42 (using the market spread to libor of 33.7bp) we get X=1.7598% - virtually the
same. No surprise because the cash flows are all close to zero (X/2 - 0.6887 = 0.191; X/2 - 1.0724
= -0.194).

3) Futures for Building the Curve

Futures are the correct instruments for building the swap curve, not 6-month and 12-month libor.
The 3-month eurodollar futures contracts are correct because:

• They are liquid and can be traded easily and cheaply

• On expiry they match the 3-month libor (which are the floating-side payments for standard
US dollar swaps)

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 Figure 1: Cash Flows for 1-year Swap - Projected CFs from 6mth & 1yr Libor
X/2 X/2

0 days 182 days 365 days

0.688746 1.0724
Cash Flows for 1-year swap with semi-annual fixed and floating payments, using
6 month and 12 month libor rates from the table in Table 1. Note that these
projected cash flows are not those used by the market for building the one-year
swap rate - the market will use 3-month libor and the forwards implied from the
futures market.

Table 2: Libor Quoted vs Futures Synthetic Instruments

qmm amm sab
Actual USSW1 1.2965%
Actual US0006M 1.36239% 1.3813%
Synthetic 6mth 1.127% 1.143%
Actual US0012M 1.74428% 1.7607%
Synthetic 12mth 1.283% 1.298%
Quotes from Bloomberg for 23-feb-2017, US dollar one-year swap (semi
30/360) and US dollar libor (A/360 money-market). Original quotes
italic / underlined. Synthetic deposit (libor-like) instruments calcu-
lated using EDSF, shown in Figure 2.

• As a result they provide the market hedging instruments - they can be traded and they match
the floating-side payments for a swap

The 6-month and 12-month libor instruments are neither liquid (are not easily and cheaply traded)
nor do they match the floating-side payments from swaps.
The Bloomberg screen EDSF shows the futures strip and synthetic FRAs. We can use the screen
to construct the synthetic 6-month and 12-month libor-like instruments based on futures. Figure 2
shows this.
Table 2 summarizes the actual and the synthetic quotes for February 23rd. The synthetic libor
instruments from futures do not match the actual libor. The synthetic 12-month libor is close to the
actual 1-year swap rate - slightly higher as it should be because the 1-year libor rate is a zero-coupon
rate and so should be slightly above the 1-year swap rate which is a par-bond rate.
The fundamental puzzle, then, is not that the 1-year swap and the 1-year libor are priced differently,
but rather that the 1-year libor and the futures are priced differently. One might think this provides
an arbitrage opportunity - lend money at the high 12-month libor rate and hedge with futures. But
in practice this will not work. First, there is a wide (maybe 20bp) spread between bid and offer
for deposits (libor). You may not receive the high rate for lending money that you would have
to pay for borrowing. (Remember, libor is the offered or ask rate - you may well lend at 20bp
lower.) Second, you will have to find the money to lend. That is expensive. (Transactions costs for
futures, in contrast, are low.) Finally, you will be taking on credit risk - if you lend the money your
counter-party may default and you will lose the full amount you lent.

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 Figure 2: Bloomberg EDSF for 23-feb-2017

Bloomberg quotes for 3-month Eurodollar contracts and calculations for synthetic FRA - note the first
three rows of the bottom part of the table - these show a one year, six-month, and six-month forward
six-month synthetic deposit (libor-like) instrument.

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For all these reasons (and others) it is difficult and expensive to arbitrage the difference between
12-month libor and futures.

4) 3-month versus 6-month libor basis

The final issue, which does not really have a bearing on the original question of differences between
USSW1 and US0012M, is the basis between 3-month and 6-month libor. Specifically, what difference
does it make if the floating legs on a swap are 6-month libor resets versus 3-month libor resets? With
single-curve valuation where everything is projected and discounted at libor it seems that should
have no effect - libor is libor and the floating payments will be the same if reset every 3 months or
6 months. But there is a difference.
In Bloomberg if you change the floating legs on a swap in SWPM from 3-month to 6-month the fixed
rate will jump about 20bp. In fact there is a market for swapping 3-month versus 6-month floating
libor (floating on both sides). These swaps are traded and the price on such a swap for one-year on
February 23rd was about 20bp. (The ticker for the one-year swap is USBC1 <curncy>.)