ABSTRACT
In this chapter, we provide an economic analysis of the post-crisis multi-curve reality of financial markets, an important feature underlying several aspects of the studies carried out in this book.
The 2007 subprime crisis induced a persistent disharmony between the Libor derivative markets of different tenors and the OIS market. Commonly proposed explanations for the corresponding spreads refer to a combined effect of credit risk and liquidity risk. However, in the literature, the meaning of liquidity is often not stated precisely, or it is simply defined as a residual spread after removal of a credit component. In this chapter we develop a stylized indifference valuation model in which a Libor-OIS spread (named LOIS in Bloomberg) emerges as a consequence of:
• on the one hand, a credit component determined by the skew of the CDS curve of a representative Libor panelist (playing the role of the “borrower” in an interbank loan),
• on the other hand, a liquidity component corresponding to the volatility of the spread between the funding rate of a representative Libor panelist (playing the role of the “lender”) and the overnight interbank rate.
