Interest Rate Derivative Pricing when Banks are Risky and Markets are Illiquid

by Geoffrey R. Harris of the Illinois Institute of Technology, and
Tao L. Wu of the Illinois Institute of Technology

May 17, 2011

Abstract: We examine the relative values of interest rate derivative contracts and cash LIBOR, particularly during the credit crisis from 2007 until present. There are substantial deviations from the results predicted by standard arbitrage pricing theory. We analyze the historical behavior of these deviations and their relationship to market measures of credit risk and liquidity. We introduce four different stochastic models of credit risk and liquidity, which make specific predictions of how these pricing deviations depend on the maturity of the contracts and the tenor of the underlying LIBOR rates. We then compare these predictions to empirical observations of the relative values of different forward rate agreements.

JEL Classification: G12, G13, G01.

Keywords: Interest Rate Derivatives, Interbank Markets, Eurodollar Futures, Forward Rate Agreements, Credit Risk, Liquidity Risk, Credit Crisis, Financial Crises

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