I apologize if this is supposed to be obvious, but ... . Libor spot rates are quoted up to a year, beyond that one can use Eurodollar futures to continue to build the curve. Let's say up to 3 years. Beyond that one can ... well that is what I don't know. Google says "benchmark swaps", but that is the "chicken or egg" problem. Presumbably swap rates can be derived from Libor forward rates and vice versa. But where are they coming from? It can't be Treasuries due to lack of AA credit risk. It can't be corporates. They're not quoted with the BBA (unless I'm wrong). So if you had to trade the first and only swap in the world, where would you get the swap rate for say 5 to 30 years?
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2$\begingroup$ When two interest rates really love each other, they... well... you know. $\endgroup$– Joshua UlrichOct 13, 2012 at 13:44
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$\begingroup$ Cute, but ... is there a real answer? $\endgroup$– PBD10017Oct 14, 2012 at 0:35
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1 Answer
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The short answer is that Libor swap rates come from the market. They represent a series of cashflows in the future whose value is determined by the fixing, which the market participants have their own valuations of.
Since the actual cash flows are now discounted using a separate funding curve, the swap prices embed both a prediction of future fixings and a measure of counterparty risk.
Libor no longer represents the actual cost of funding in the market, so Libor instruments involve buying or selling exposure to this Libor fixing index, which is now only correlated to funding costs.
You are asking for the arbitrage path/replication basket, for which there is only a series of FRAs funded with your funding curve - nothing else will give you the Libor exposure you need in the resulting basket.
Swaps are the market's medium to long term interest rate instrument.
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1$\begingroup$ I like this answer (upvoted), you should probably mark this as the correct answer. Very concise and comes from an obvious market practitioner. $\endgroup$ Oct 20, 2012 at 14:21
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$\begingroup$ Phil H, when you say "is determined by the fixing" I have a little trouble understanding what you mean. I assume you're talking about OIS discounting for collateralized swaps. But still one needs Libor (3M, 6M) forward rates in the future. Where would those come from? On top, I assume not all swaps are collateralized and that would still require a different discount curve. $\endgroup$– PBD10017Oct 23, 2012 at 14:42
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1$\begingroup$ The broad point is that you get the fixings implied by the swaps, not the other way around. Today's swap prices give a set of implied fixing expectations, which can be then used to imply FRAs, spreads, etc. The risk is in Libor diverging more from funding costs, as that can't be directly hedged without swaps or perhaps swaptions. $\endgroup$– Phil HOct 25, 2012 at 9:42