I'm building out a calibrated USD MultiCurve set, focusing on Fed Funds & 3M LIBOR for the purpose of trading in Fed Funds Futures and Eurodollar Futures (for now ...).
I had always assumed that the OIS/Fed Funds rate (perhaps with a turn-of-calendar spread adjustment) was used as the discounting curve itself. In reading Darbyshire's excellent Pricing and Trading Interest Rate Derivatives, I came across another rate (the Interest on Excess Reserves) that seems to have some merit as the true discounting basis.
- It is truly a risk-free rate, being the interest on deposits held at the Fed rather than unsecured overnight lending.
- It is, I believe, the interest offered on margin at the CME.
On the other hand, due to the fact that the Fed Funds rate reflects lower-than-IOER loans made from banks unable to earn interest on reserves to US Branches of Foreign Banks, the Effective Fed Funds rate is often lower than the IOER.
Question: given my interest in trading futures, which is the more theoretically sound USD MultiCurve setup?
- OIS/Fed Funds forecasting + 3M Libor forecasting, with an EFFR vs. IOER spread to the discounting curve, or
- OIS/Fed Funds (forecasting + discounting) + 3M Libor forecasting.