Bootstrapping the LIBOR Curve & Improving Forward Rate Interpolation

With the heightened focus on credit markets since the 1998 credit meltdown and the shrinking supply of U.S. Treasury Notes and Bonds, the importance of the LIBOR market has increased significantly. This increased emphasis caused us to revisit the methodology for constructing the LIBOR curve and improve upon the interpolation methodology for computing LIBOR forward rates. The LIBOR curve is constructed using a bootstrap process. Marks on liquid instruments with increasing maturities are used to imply arbitrage free forward rates. The instruments used to construct the curve are as follows: money market rates for short maturities, Eurodollar futures contracts for intermediate maturit ies, and swap spreads/rates for long maturities.

Bootstrapping the LIBOR curve entails creating a discount function, which represents the present value of a dollar to be received in the future. From this discount function all other curves, e.g. spot, par, forward, can be derived. The discount function should have a value of 1 today and monotonically decrease with maturity. For the first part of the bootstrapping process we use money market where rates which are quoted for 7d, 1m, and 3m maturities. It is straightforward to calculate the appropriate discount using the following formula:

(t) =
Where

1 . 1 + ( t0 , t ) L(t 0 , t )

(t ) is the present value of a dollar at time t,

(t 0 , t ) is the day count fraction from time t0 to t, and L( t0 , t ) is the money market rate for the period t0 to t. The day count basis used to calculate in the US dollar market is Act/360.
Money market rates are used to determine appropriate discounts only until the next IMM futures contract settlement date. At that point Eurodollar futures quotes are used to determine implied forward rates. IMM dates occur the Monday prior to the third Wednesday of March, June, September and December. Eurodollar quotes can be converted to implied forward rates by subtracting the quote, q, from 100. If we let ti represent the IMM date of the i-th Eurodollar futures contract and log-linearly interpolate the money market discount factors to determine ( t1 ) then subsequent Eurodollar futures contract discount factors can be calculated via:

( t i+1 ) =

(ti ) . 1 + ( t i , t i+1 ) (1 qi / 100)

BlackRock Solutions

Page 1 of 3

Confidential & Proprietary

Bootstrapping the LIBOR Curve& Improving Forward Rate Interpolation

This procedure continues up until the two year point where swap rates are used to complete the boot strap process. Swap rates are determined by adding a quoted swap spread to the on-the-run (OTR) Treasury rate. For tenors of less than 10 years the quote is with respect to an interpolated rate and for greater than 10 and less than 30 years the spread is with respect to the 10 year OTR rate. The swap rate is the rate at which the value of the swap is zero. Since the floating leg of the swap is worth par this implies that the fix leg must also be worth par

1 = rn fix (t i1 , ti ) ( ti ) + (t mn ) .
i =1

m n

Where

rn is the fixed rate for a swap of tenor n years which pays a coupon of frequency m, and fix (t i1 , t i ) is the day count fraction from time ti-1 to ti for the fixed leg of the swap.
For US dollar swaps the fix leg pays a semiannual coupon and day counts are determined using a 30/360 basis, or m = 2 and fix = 1 / 2 . Our goal is to determine the discounts that make the above relationship true subject to the prior constraint

( ti ) > (t j ) with t i < t j .

One approach is to interpolate the swap rates and then successively solve for the discounts in six-month steps. This is the current methodology used in production. It is simple, fast, and the resulting discount function gives reasonable results. This approach, however, leaves us with a jagged forward curve with discontinuities in the forward rate every six months. An alternative approach, which does not suffer from the same problems, is to use log-linear interpolation on the discount function to determine the intermediate points. This approach requires an interative search to find the discount at t2n that solves the above formula. While this is modestly slower than the aforementioned algorithm it yields a much smoother and well-behaved forward curve. A plot of the resulting 3m forward rates is shown at the top of the next page. As can be seen the new approach still has some discontinuities, however, these occur at actual data points and such discontinuities are an artifact of the bootstrap process.

BlackRock Solutions

Page 2 of 3

Confidential & Proprietary

Bootstrapping the LIBOR Curve& Improving Forward Rate Interpolation

3m Forward Rates
8 7.8 7.6

Forward Rate

7.4 7.2 7 6.8 6.6 6.4 6.2 6 20000103

20050103

20100103

20150103

20200103

20250103

20300103

Date
3m Fwd 3m Fwd (new)

The difference between the resulting discount functions is so small that the two curves cannot be distinguished on the same plot. Below the difference between the resulting discount functions is plotted. Please take note of the size of the differences.

Difference in Discount Functions

0.0005 0.0004 0.0003 0.0002 Difference 0.0001 0 -0.0001 -0.0002 -0.0003 -0.0004 -0.0005 20000103

20050103

20100103

20150103 Date

20200103

20250103

20300103

The small differences above give rise to similarly small differences in valuations. It should be noted that with suitable choices for day count basis and frequency of coupon payment this methodology has been easily extended to non-dollar LIBOR markets as well.

BlackRock Solutions

Page 3 of 3

Confidential & Proprietary