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Basis Curve The term structure of an interest rate basis curve is defined as the relationship between the basis zero rate and it’s maturity. Basis curves are used as the forecast curves for pricing interest rate products. The increase in basis spreads has resulted in large impacts on non-standard instruments. The basis curve construction methodology is based on the most liquid market instruments. Normally a basis curve is divided into two parts. The short end of the term structure is determined using LIBOR rates and the remaining is derived using basis swaps. The increase in basis spreads or basis zero rate spread has resulted in large impact on pricing non-standard instruments. Basis curve acts as forecast curve in model input for valuing financial products. Hence, basis spread curves are required for getting accurate pricing, ypical basis curves are 1 month, 6 months, 12 months, Prime, FedFun, and OIS. A 1-month basis curve is displayed below. Note that the market quote of a basis swap rate is the spread over the associated 3 month reference rate.
The term structure of a basis curve is constructed from a set of market quotes of some liquid market instruments Normally a basis curve
is divided into two parts. The short end of the term structure is determined using LIBOR rates. The remaining is derived using basis swaps.
A basis swap is quoted on the spread of the basis leg as follows
The objective of the bootstrap algorithm is to find the zero yield or discount factor for each maturity point and cash flow date sequentially so that all basis curve instruments can be priced back to the market quotes. All bootstrapping methods build up the term structure from shorter maturities to longer ones. Reference |