Libor Benchmark Reform: An Overview of Libor Changes and Its Impact on Yield Curves, Pricing and Risk

Abstract

Libor is arguably the world's most important number, with more than USD 200 trillion of derivatives, loans, securities and mortgages referencing this rate in the US markets alone. The Libor benchmark rate is being replaced with alternative reference rates (ARRs) and there is no guarantee the rate will continue to be quoted beyond 2021. In this paper Libor benchmark rate reform is discussed in detail and we assess the impact this has on yield curve construction, interest rate pricing and risk. We highlight why Libor is important, review its history and how it has evolved, which leads to a discussion as to what is wrong with Libor benchmarks. We outline market terminology with regards to both interest rates and yield curve construction, before proceeding to assess on the impact of Libor reform, reviewing the new benchmarks, fall-back rates and yield curve changes. We review yield curve calibration and in doing so provide many charts and Excel workbook illustrations to demonstrate new features of ARR yield curves. We explain how to both bootstrap and globally calibrate curves to imply forward rates & discount factors. Moreover, we outline the interpolation, optimization and solving process, showing how to calibrate curves in such a way to capture the necessary risk metrics required to compute analytical risk and rebuild curves for ultra-fast performance. It is hoped this paper will serve as a useful Libor benchmark rate reform and yield curve primer.