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INTEREST RATE SWAPS: A COMPARISON OF COMPOUNDED DAILY VERSUS DISCRETE REFERENCE
RATES



27 Pages Posted: 10 May 2021 Last revised: 7 Sep 2021

See all articles by Robert Jarrow


ROBERT JARROW

Cornell SC Johnson College of Business


SIGUANG LI

Cornell University, Dept. of Economics

Date Written: May 7, 2021


ABSTRACT

This paper studies the hedging effectiveness of interest rate swaps using
different reference rates for eliminating interest rate risk from floating rate
loans. Two different reference rates are studied. The first is a reference rate
whose maturity, ∆, matches the payment interval of the floating rate loan. The
second is a reference rate whose maturity is ∆/N. The prime examples are LIBOR
and SOFR, respectively. We show that the ∆-based interest rate swap provides a
good static hedge, but the ∆/N-based swap does not. Although dynamic hedging
with the ∆-based interest rate swap is possible under some conditions, it both
introduces model risk and increases transaction costs, making it a less
practical alternative.



Keywords: Interest Rate Swaps, LIBOR, SOFR, Floating Rate Loans

JEL Classification: E43, G12, G13, G21

Suggested Citation: Suggested Citation

Jarrow, Robert and Li, Siguang, Interest Rate Swaps: A Comparison of Compounded
Daily Versus Discrete Reference Rates (May 7, 2021). Available at SSRN:
https://ssrn.com/abstract=3841313 or http://dx.doi.org/10.2139/ssrn.3841313


ROBERT JARROW

CORNELL SC JOHNSON COLLEGE OF BUSINESS

Ithaca, NY 14850
United States



SIGUANG LI (CONTACT AUTHOR)

CORNELL UNIVERSITY, DEPT. OF ECONOMICS ( EMAIL )

404 Uris Hall
Ithaca, NY Tompkins 14853
United States


HOME PAGE: http://www.siguangli.com


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17 REFERENCES

 1. Abrantes-Metz, M Rosa, Michael Kraten, Albert D Metz, Gim S Seow
    
    
    LIBOR MANIPULATION?
    
    Journal of Banking & Finance, volume 36, issue 1, p. 136 - 150
    Posted: 2012
    Crossref
 2. Markus Baldauf, Christoph Frei, Joshua Mollner
    
    
    PRINCIPAL TRADING ARRANGEMENTS: WHEN ARE COMMON CONTRACTS OPTIMAL?
    
    Management Science, Vol. 68, No. 4, pp. 3112–3128,
    56 Pages · Posted: 24 May 2018 · Last revised: 3 May 2022
    Download PDF Add Paper to My Library
    Download PDF
    Add Paper to My Library
 3. Pietro Bonaldi
    
    
    
    
    Motives and Consequences of Libor Strategic Reporting: How Much Can We Learn
    from Banks' Self-Reported Borrowing Rates?
    Posted: 2017
 4. Kalok C Chan, Andrew Karolyi, A Francis, Anthony B Longstaff, Sanders
    
    
    AN EMPIRICAL COMPARISON OF ALTERNATIVE MODELS OF THE SHORT-TERM INTEREST
    RATE
    
    The Journal of Finance, volume 47, issue 3, p. 1209 - 1227
    Posted: 1992
    Crossref

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