Wednesday, 26 September 2007

Lending decision based on counterparty shock

Over at the FT there is a slightly sensational article Libor’s value is called into question. Apparently it surprises the writer than an average rate like Libor is not everyone's cost of funds. Surprise, some banks are funding significantly sub-Libor at the moment, and some way, way over.

The FT raises the concern that some players may have written derivatives contracts referencing Libor and now discover that this index does not reflect their cost of funds. Most derivatives traders worked out that arb sometime in the late 80s: Treasury pays L-10 but the pricing system assumes you fund at Libor flat, so if you can raise money at L-5 you book a profit vs. the model and treasury eats the loss (or at least it did before transfer pricing caught up with that little game). Anyone who didn't understand that writing a contract based on an average interbank rate introduces funding basis risk shouldn't be allowed to write something that will be with the holder for many years.

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