Forecasting multiple-term structures from interbank rates

Abstract

The classic relationship between deposit rates and interest rate derivatives has been fractured since August 2007. Uncertainty in the interbank money market has increased the risk premia differentials on unsecured deposit rates of different tenors, such as Euribor, leading to a new pricing framework of interest rate derivatives based on multiple discount curves. This article analyzes the economic determinants of this new multi-curve framework. We employ basis swap (BS) spreads – floating-to-floating interest rate swaps – as instruments for extracting the interest rate curve differentials. Our results show that the multi-curve framework mirrors the standard single-curve setting in terms of level, slope and curvature factors. The level factor captures 90% of the total variation in the curves, and this factor significantly covariates with the spread between financial and risk-free bond yields, a proxy of systemic risk. This variable anticipates future movements of the curve level for all tenors. Moreover, unidirectional causality running from market-wide liquidity to curve residuals is also detected. Finally, we show how the information content in liquidity and systemic risk could improve the forecastability of interest rate curves under financial distress.