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Infinity
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Posts: 5
Joined: August 9th, 2002, 9:02 am

Curves to use when pricing basis swaps

June 9th, 2008, 2:55 pm

I need to price the spread of a USD-USD basis swap, for e.g.:- Receive : USD 6M Libor- Pay : USD 3M Libor + spread,Using basis swap market prices, we can build a basis swap curve from the market yield curve. When pricing the above basis swap (any reasonable maturity), which of these two curves should I be using as the discount and forward curves of the two legs? Please help me to understand why.Thank you.
 
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unkpath
Posts: 289
Joined: January 13th, 2004, 8:44 pm

Curves to use when pricing basis swaps

June 10th, 2008, 1:04 am

hi, once you have the curves, then you should use the 6M Libor curve to imply 6M forwards and the 3M Libor curve to imply 3M forwards. In the absence of a separate discount curve, then use the 3M Libor curve to do your discounting for all cashfows.In the US, that has been the standard up to "now". 3M Libor is benchmark interbank rate, the most liquid one. Other rates are expressed with respect to it, as is the case for your basisswaps. Most banks will have assumed since the late 80s/early 90s that this is the rate they can fund at, hence that rate should be discounted at. read some of the older posts in this forum.this picture is about to change. by now, most serious ibs will have deployed r&d teams and research on yield curves and are developing much more refined tools. in the future it is unlikely that the 3M curve will be used for discounting and anyway curve bootstrapping algorithms will have to change in order to reflect the craziness going on in the markets.QuoteOriginally posted by: InfinityI need to price the spread of a USD-USD basis swap, for e.g.:- Receive : USD 6M Libor- Pay : USD 3M Libor + spread,Using basis swap market prices, we can build a basis swap curve from the market yield curve. When pricing the above basis swap (any reasonable maturity), which of these two curves should I be using as the discount and forward curves of the two legs? Please help me to understand why.Thank you.
 
User avatar
Infinity
Topic Author
Posts: 5
Joined: August 9th, 2002, 9:02 am

Curves to use when pricing basis swaps

June 10th, 2008, 5:53 am

Many thanks for your help, unkpath.Need to confirm my understanding.Supposing I denote the 3M Libor curve by “YC”, and the basis swap curve (built using market price of 6M vs 3M Libor basis swaps and YC) by “BSC”. Then, based on current practice, am I right to use the following? Conceptually, what's the difference if I use the following?
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