Lecture 7: Linear Rates, Products, and Models

Quick Overview

Andrew Gunstensen details the fundamentals of linear interest rate products, emphasizing that while seemingly simple, their modeling and valuation, especially post-2008 financial crisis, require careful consideration of funding rates, discounting, and the massive transition away from LIBOR to replacement rates like SOFR.

Key Points: Linear products like bonds, interest rate swaps, and futures are the core underlying of the largest markets on the planet, with interest rate swaps outstanding north of $500 trillion. The speaker strongly discourages focusing only on complex math, stating, "we wouldn't spend 80% of the time talking about hammers" when building a house, prioritizing the problems being solved. The 2008 financial crisis highlighted issues with previously simple products, leading to increased regulation around model risk management and driving a shift away from complex exotics. A critical concept taught is that funding and discounting rates must be the same to avoid arbitrage: "funding and discounting are the same." LIBOR, the London Interbank Offered Rate, was retired because it was based on polled estimates rather than actual transactions, leading to manipulation scandals and lack of transactional support. The US transitioned to SOFR (Securitized Overnight Funding Rate), which is based on the average of overnight repo trades, though SOFR has operational drawbacks like being a daily rate and being secured, unlike unsecured LIBOR. Valuing interest rate swaps involves calculating the present value of the fixed leg and the floating leg, requiring one curve for forward rates and another for discounting factors, though in vanilla swaps, they are both the SOFR curve.

Context: Andrew Gunstensen, Head of Quantitative Strategies at Mizuho, delivers a lecture on linear interest rate products, covering basics like interest rates, liquid products, yield curves, hedging, and e-trading. The presentation is deliberately "nonmathy," focusing on practical relevance, especially in light of market changes following the 2008 global financial crisis, particularly the necessity of replacing the LIBOR benchmark rate.