OK, what's going to follow will sound like plain banality to credit risk folks or market risk people somehow involved in credit risk. It is also a digression in a blog focused on the FX related world. But sounded interesting to me, so decided to share.
It's basically a simple fact I was told about recently by a credit risk expert (yeah, don't want to sound like I came up with a smart idea when someone brought the fact to me, so should at least mention it upfront...) and which struck me for multiple reasons: (1) theoretically easy to understand (2) has a lot of practical applications for anybody crunching market data for any use (3) it is an original angle from which to witness the changes pre and post credit crisis.
So here is the deal: a few years ago, it was quite standard to build a risk free rate curve using vanilla swap rates for durations above 2 years(ish). We were talking about liquid instruments, traded in massive volumes, representing an industry standard and free of credit risk... That is a few years ago.
Indeed, going back to a simple feature of vanilla IR swaps, these carry coupons which, depending on the underlying currency, get paid quarterly, bi-annually or sometimes annually. Now let's look at what happens even in the highest standard coupon frequency, ie the quarterly one. Well, technically, on a given swap leg paying 3-months coupons, the long position holder is lending cash to his / her counterparty for a quarter like on any loan. So in a way, he / she is short credit risk. The point is that nobody used to care about that subtle point and was more than happy to use swap rates considering them as risk free.
But things changed since 2007, and 3 months now sometimes seem like an sweating eternity... So credit risk guys decided to shift gear and started considering that the only duration worth being considered short enough to carry the risk free name was the overnight one. And consequently, they started replacing vanilla swap rates with OIS swap rates when building risk free rate curves.
Another way to get a grasp on that difference would be to monitor the spread between Libor rates and OIS rates. These used to be as small as 10 pips, but in the tensed hours of the credit crisis in September 2008, they surged to multiples of hundreds of pips...
Source: Bloomberg.com
