1

ON EXTENDING OIS CURVES USING FED

FUNDS BASIS SWAP QUOTES
February 23, 2010

SUMMARY
CurrentlyforUSD,OvernightIndexedSwap(OIS)ratesarenotquotedinthemarketplacebeyondthe
10yearmaturity.InordertosupportOISdiscountinganddualcurvestripping,itisnecessarytoextend
theOIScurvesbeyondthe10yearmaturity.Thisdocumentproposesandevaluatesseveralrelated
methodsforextendingtheOIScurvestothe30yearmaturitybyharnessingUSDFedFunds(FF)basis
swapquotes.IncontrasttoextrapolationofforwardratespreadsusingonlyLibor1,
1
thesemethods
shareacommontraitthattheyallattempttoderiveOISratesusingbothLiborandFFbasisquotes.
1. Method1:ItbootstrapsOIScurvestomatchmarketquotesofFFbasisspreadswhileusingOIS
curvestoprojectFFEffectiveRateduringFFbasisswapevaluation.
2. Method2:ItsolvesforfixedcouponsinLiborswapswithappropriatebasisandconvention
adjustmentsandusesthemasapproximateOISrates.
3. Method3:ItcalculatesOISratesdirectlyfromLiborandFFbasisquotesusingapproximate
conversionformulaetoaccountforconventionadjustments.
Crossvalidationanalysisisperformedtoevaluatethesemethodsusingrealtimeandhistoricaldataof
10YOISswaps.Arecommendationisthenmadebasedonthecrossvalidationresultsaswellas
considerationsofcomputationalcomplexity.

BACKGROUND
OIS Swaps
AnOvernightIndexedSwap(OIS)isafixed/floatinginterestrateswapwiththefloatinglegcomputed
usingthepublishedFFEffectiveRate(FEDL01).Twopartiesagreetoexchangethedifferencebetween
interestaccruedatthefixedrateandinterestaccruedatthecompoundedfloatingrateontheagreed
notionalamountoftheswap.AsshowninFigure1,OIScurvesS42areusedforprojectingthedaily
forwardsofFEDL01,aswellasfordiscountingthecashflows.
Fed Funds Basis Swaps
TheFedFundsbasisswapisafloatfloatswapversus3monthLibor.AsshowninFigure2,twoparties
agreetoexchangethedifferencebetweeninterestaccruedatthe3MLiborrate(US0003M)andinterest
accruedatthenoncompoundeddailyweightedFFEffectiveRate(FEDL01),plustheFFbasisspread
(USBG10intheexample)ontheagreednotionalamountoftheswap.HeretheFFbasiscurveS85is
usedforprojectingthedailyforwardsofFEDL01.

1
KirillLevin,Dualcurvestrippingoftheswapcurve(IDOC#2053281).

Figure 1: Example of 5Y OIS swap (SWPM -OIS 5Y <Go>)

Figure 2: Example of 10Y FF swap (SWPM -FF 10Y <Go>)

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Exploring Relationships between OIS and FF Basis Swaps
Despitehavingdifferentconventionssuchaspayfrequencyandcompounding,bothOISandFFbasis
swapsaredefinedintermsoftheFFEffectiveRate.Notethattheircashflowsarecalculatedbasedon
theforwardsofthesameindexFEDL01,projectedfromthecurvesS42andS85,respectively.Inother
words,OISswapsandFFbasisspreadsareobservablesofthesameunderlyingsecurityandtherefore
sensibleinferencesfromeachothershouldbepossibleinanarbitragefreeenvironment.Allthree
methoddescribedinthisdocumentareaimedatexploringsuchrelationshipsbetweenOISandFFbasis
swaps.
Aquickanddirtysanitycheckwasperformedtoconfirmfeasibilityofcrossinference.AnamedLibor
curve,FEDFUND,iscreatedbysimplysubtractingFFbasisspreadsfromaLiborswapcurveconstructed
withratesofmatchingmaturities.Theimplied10YswapratesinLiborswapdealsevaluatedusingthis
namedcurvearegenerallywithinacoupleofbpsfromthequoted10YOISrates.Forexample,the
quoted10YOISfor1/19/11is3.106%,whiletheimpliedLiborswapratefromFEDFUNDnamedcurveis
3.1245%(withanerrorof1.85bp).

METHODS FOR EXTENDING OIS CURVES

Figure 3: Market quotes for 10Y Libor and OIS rates

Cross-validation Baseline
InanefforttopredicthowwelltheywillperforminestimatingOISratesbeyondthequoted10Y
maturity,crossvalidationisusedtoevaluatetheextrapolationmethods.Itiscarriedoutprimarilyfor

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the10YOISswapsbycomparingquotedagainstimpliedratesfromvariousmethodsusingonlyOISrates
tothe5Ymaturity.
Beforeintroducingtheextrapolationmethods,letusestablishabaselineusingmarketquotes.Figure3
showsthe10YLiborandOISratesbetween8/1/08and2/7/11.(Analysiscannotgobackfurtherbecause
quotesfor10YOISonlybecameavailableinlateJuly2008).WhenthedifferencesbetweentheLiborand
FFbasisareusedasroughestimatesofOISrates,weobservetheresultingerrorshavingapositive
averagebiasof1.79bpandcanbequitelargeattimes(Figure4).Theselargeerrorsarelikelydueto
marketinconsistencieswhentheLiborandOISratesarenotinsyncwitheachother,especiallyifthe
closingquotesarefromdifferentcontributorsandatdifferenttime.

Figure 4: Extrapolation errors if Libor minus FF basis were used to estimate OIS

Theaboveconjectureiscorroboratedwhenthebehaviorofrealtimequotesisobserved.Figure5shows
realtimemarketquotesofLiborandOISrateson2/18/11(BGN).NotethatLiborandOIStrackeach
otherquitewell,exceptforsmallratespikesthatappearedonlyinoneofthem.Theaveragebiasofthe
errorsisabout1bpaftertakingintoaccounttheFFbasis(Figure6).Giventhelikelymismatchinclosing
ticktimeandcontributorsourcesbetweenLiborandOIS,itislikelythattheexcesserrorsobservedin
Figure4willbereducedtoasimilarlevelasinrealtimequotesifgoldencopieswereusedasthe
historicaldatasource.
Theobservederrorcharacteristicsatclosingtimeshouldalsoserveasawarningfornotusingratesthat
maynotbeconsistentwitheachotherforcrossinferencepurposes
Asillustratedlaterinthisdocument,experimentscarriedoutusingmismatchedquotescanleadto
misleadingconclusions.

Figure 5: Market quotes for 10Y Libor and OIS rates on 2/18/11

Figure 6: Extrapolation errors if Libor minus FF basis were used to estimate OIS (2/18/11)

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Method 1: Bootstrapping OIS Curves to Match FF Basis Spreads
GiventhattheOIScurveS42andtheFFbasiscurveS85arebothintendedtoprojectforwardsofthe
sameFFEffectiveRate(FEDL01),thevaluationofOISswapsandFFbasisswapscanbecarriedoutin
principleusingprojectionsfromeithercurve.Inourcase,weuseS42toprojectFEDL01whenevaluating
FFswapsinanefforttobootstraptheOIScurves.
Figure7illustratesthisbootstrappingprocesswithanexample,whileitsdetailsarefoundinAppendixA.
SupposehypotheticallythatOISswapsarequotedonlytothe5Ymaturityandweneedtocalculatethe
10YOISratefromthe10YFFbasisspread(inconjunctionwiththe10YLiborswaprate).A10Yfixedfloat
FFbasisswapcanbesetupasfollows:Afixedlegreceives10YLiborswap(USSWAP10),andafloating
legpaysdailyaveragedFFrate,plusbasisspread(USBG10).Notethatthefixedlegisequivalenttothe
3MLiborfloatingleginFigure2.
ThePVofthefloatinglegisdependentoncurveS42inwhichallswapratesareknownexceptthe10Y
maturity.Therefore,the10YOISratecanbesolvedbyequatingthePVsofbothlegs.Bycarryingout
rootsolvingmanuallyusingrateadjustmentintheCurvestabofSWPMfunction,the10YOISrate
impliedfromFFbasisis3.1231%(Figure8).
2
Comparedtothequotedrateof3.106%,theextrapolation
erroris1.71bp.Forreference,Liborminusbasis(3.4095%0.285%=3.1245%)producesaslightlylarger
errorof1.85bp.

Figure 7: Example of calculating OIS rate from FF basis and Libor swap rate

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Thepremiumisnotexactlyzeroduetolimitedprecisionof0.01bpforrateshift.

Figure 8: Manual root solving using SWPM

SmallererrorsbetweenimpliedandquotedratesareoftenachievedwhentheOIScurveisusedfor
discountinginsteadofS23(Figure9).ThisisequivalenttostripS23usingOISfordiscounting.Inour
example,theimpliedratebecomes3.1134%,whichresultsinasmallerextrapolationerrorof0.74bp.
Notethatthelegsarenolongeratparnow.
Inordertogaininsightonhowthisextrapolationmethodbehaves,anofflineprogramhasbeencreated
torepeattheabovestepsprogrammatically.Figure10showstheextrapolationerrorsbetweenimplied
andquotedrealtime10YOISratesduringbusinesshoursof2/18/11.Aremarkableagreementis
observedbetweentheimpliedandquotedrateswithanaveragebiasofonly1/4bp.Ifitwerenotfor
thesmallspikesintheLiborrate,theerrorswouldallbewithinthe0and1/2bpband.Thissmallbiasis
likelytheresultofnotmakingaconvexityadjustmentinFFbasisswapvaluation.
Priortoapplyingtheofflinetorealtimequotes,ithasbeenusedonhistoricalclosingquotesforcurve
datesbetween8/1/08and2/7/11.Figure11showstheresultingextrapolationerrorsfor10YOISswaps
(usingOISdiscounting)whicharemuchlessconsistentovertimeandexhibitonesidedbiasesthatcan
lastmonthsatatime.Thelessonhereisthatwhenmakingcrossinferencesbetweenrelatedrates,itis
essentialthattheratesaretickedatthesametimeandpreferablycomefromthesamesource.
Otherwise,ratedifferencesduetomismatchedtimeorsourcecandominatetheoutputerror
characteristicsandleadstopotentiallymisleadingconclusions.

Figure 9: OIS rate calculation from FF basis and Libor swap rate using OIS discounting

Figure 10: Extrapolation errors from method 1 observed on 2/18/11 (OIS to match FF basis)

Figure 11: Extrapolation errors from method 1 applied to historical closing quotes

Method 2: Extrapolating OIS Curves by Solving Swap Coupons

Method2attemptstoformalizetheintuitionbehindthenamedcurveFEDFUNDapproachthatwas
usedtoconfirmrelationshipsbetweenOISandFFbasis.AsillustratedinFigure12,itconsistsofsolving
forthefixedlegcouponafteradjustingconventionstomatchOISandapplyingaspreadequaltothe
minusofFFbasisonthefloatingleg.Inthisexample,theextrapolatedOISrateis3.1008%,resultingin
anerrorof0.52bp.Crossvalidationanalysisproducesextrapolationerrorsthatexhibitanegative
averagebiasof1.1bpusingquoteson2/18/11(Figure13nocompoundingadjustment).
WhilethefixedleginFigure12hasbeenadjustedforconventionstomatchOIS,thebasisspreadonthe
floatinglegisstillbasedontheweighteddailyaveragecompoundingofFFbasisswaps.The
compoundingdifferencebetweenFFbasisandOISaccountsforabout1.5bpsforthecurrentmarket
conditions.Unfortunately,thereisnoeasywaytoaccountforthecompoundingdifferenceswithout
actualdailyforwardprojection.Acrudeapproximationistoassumeaflatcurvewitharateequalto
(LiborFFbasis)andignorecompoundingforweekendsandholidays.Acorrectionofabout1.5bpsis
producedusingthisapproximationwhichreducestheaveragebiasto0.34bp(Figure13with
compoundingadjustment).Sincethesameapproximationwillbedeployedformethod3,theformula
forcompoundingadjustmentappearsinthenextsection.

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Figure 12: OIS extrapolation by solving approximate Libor swaps (method 2)

Figure 13: Extrapolation errors from method 2 using Libor discounting

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Method 3: Approximate Rate Conversion with Convention
Adjustments
Method3seekstofurthersimplytheapproximationsusedinmethod2tosimplerateconversion
formulaewithoutactuallycarryingouttheswapevaluations.Letusconsiderthescenarioshownin
Figure12.ByadjustingthepaymentscheduleandcompoundingconventionofLiborswaps,thefixedleg
couponcanbeapproximatedbyananalyticformulaifminordiscrepanciessuchasbusinessday
adjustmentareignored.Letc
N,2S
, c
N,42
,ands
N,8S
denotetheNyearLiborswaprate,OISrate,andFFbasis
spread,respectively.TheextrapolatedOISrate,
N,42
,canbeapproximatedas:

Acrudecompoundingadjustmentcanbemadebasedontheflatcurveassumption.TheOISratewith
suchcompoundingadjustment,

N,42
,iscomputedasfollows:

Figure14showstheextrapolationerrorsproducedbyboth
N,42
and

N,42
.Notethattheerrorsare
slightlylargerthanthoseproducedbytheircalculatedcounterparts.

Figure 14: Extrapolation errors for method 3 with Libor discounting

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Evaluation Summary

Table 1: Mean and standard deviation of extrapolation errors for 10Y OIS rates on 2/18/11

CONCLUSIONS
RealtimeOIS,Libor,andFFbasisquotesareconsistentamongthemselves,asevidencedbythe
remarkablysmallcrossvalidationerrorsobservedwhenOISratesarebootstrappedtomatch
theFFbasisspreadsinmethod1.
EndofdayclosingquotesarenotsuitableforuseinratecrossinferencesuchascalculatingOIS
fromLiborandFFbasis,becausetheratevariabilityduetomismatchedtimeorsourcecan
dominatetheerrorcharacteristicsandleadstopotentiallymisleadingconclusions.
Method2isnotintendedasameanstoextrapolateOISrate,becauseitoffersnoadvantagein
accuracyovermethod1orsimplicityovermethod3.Itmerelyservesasmotivationand
referenceformethod2.
Method3withapproximatecompoundingadjustmenthasemergedasastrongcontenderforits
simplicityandaccuracy.However,itsaccuracymaydeteriorateasthecurvessteepenandrates
risefromthecurrentlowlevel.
Computationaladvantageofmethod3overmethod1isnotaslargeasitappears.Whilea
bootstrappingstepisrequiredinmethod3foreachextrapolatedOISrate,itisdesignedtobe
veryefficientandmuchofitseffortcouldbecarriedovertotheOISstrippingstagefor
substantialsavings.Inotherwords,theoverallimpactonthetotalcomputationtimeforOIS
curveextrapolation/strippingisexpectedtobequitesmallcomparedtomethod3.
Insummary,methods1and3arebothrecommendedforextendingtheOIScurves.Method1is
recommendedforitssoundtheoreticaljustification,accuracy,andrelativelysmallcomputational
overheadovermethod3;method3withcompoundingadjustmentforitssimplicityandaccuracy.

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APPENDIX A
Letc
N,23
,c
N,42
,ands
N,85
denotetheLiborswaprate,OISrate,andFFbasisspreadofthematurityT
N
,
respectively.WeseektobootstraptheOISrate,c
N,42
,usingcN,23ands
N,85
,assumingthattheOIScurve
hasbeenconstructeduptothematurityT
N1
,pertheproceduredescribedinFigure9.Constantforward
interpolationisusedforcurve42duringbootstrapping.
Notation
Notation Description
t
k,i
ithcashflowpaymentdateinkthleg(k=1,2)
t
k,i
t
k,i
t
k,i1
=daycountfractionsinithpaymentperiodin
kthleg
J
t
DiscountfactorattimetontheOIScurve
r
J,N
ConstantOISdailyforwardrateintheinterval[T
N1,
T
N
).
PI
k
PVofkthleg

FF Basis Swap Using OIS Curve

ThePVsinaFFbasisswapareevaluatedasfollows:

where
r
wJ,]
=theweightedaveragedailyforwardrateinjthpaymentperiodinleg2.

n
],k
=thenumberofdaysin[t
2,]1
,t
2,]
)thataccruekdaysofinterest.
Forexample,n
],3
isthenumberofFridaysinjthperiodthatarepartofalongweekend.Notethatboth
PVsareafunctionofr
J,N
,whichcanbesolvedfromPI
1
=PI
2
.Thebootstrappingprocedurecanbe
carriedoutefficientlyusingprecomputed{n
],k
}.