Box Spreads Embedded Interest Rates

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dragonman

Hello to everyone. I have a theoretical question that bothers me for a while: how does the interest rate assumptions that are embbeded into a European style cash-settled box spread are being determined?

For example, if there is a box spread which is 10 points apart which expires within one year, does its price should exactly reflect the current yeild on a one-year tresuary (which is about %0.15, so that the box price should be no higher or lower than 9.985)?

Does the box price can reflect interest rates that are substantially different from a one-year treasury and if so on what benchmark it may be based (i.e., any specific benchmark other than the treasury yield, the trader's own cost of borrowing/lending or any other benchmark)?

Thanks in advance for any feedback.
 
It's a complicated question and I could wax poetic on the subject, if you like.

The short answer is that I think most mkt participants probably use 1y FF OIS rate these days.
 
Quote from Martinghoul:

It's a complicated question and I could wax poetic on the subject, if you like.

The short answer is that I think most mkt participants probably use 1y FF OIS rate these days.
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If you can elaborate on this matter it will be great (and also explain what is excatly FF OIS), thanks.
 
Quote from dragonman:
If you can elaborate on this matter it will be great (and also explain what is excatly FF OIS), thanks.
More...
FF OIS = FedFunds Overnight Index Swap

Basically, PV of anything you own is determined by your very own cost of capital (the rate at which you discount future cashflows needs to be equal to the rate at which you fund yourself; otherwise, there's arbitrage). Obviously, it would be impractical if different mkt participants couldn't agree on a price of an otherwise fungible security due to different discount rates. So there's an implicit "fudge" where everyone kind of accepts the same rate (in most cases it would be driven by the exchange).

As to the rate itself, in the pre-crisis past, it didn't matter too much and everyone was happy to use LIBOR rates. The crisis did two things: a) exposed all sorts of nasty LIBOR issues; b) opened peeps' eyes to the fact that the choice of discount rate has economic significance. So now the mkt has kinda settled on a common denominator, i.e. OIS rates.

Now, as I have mentioned before, my experience is not specifically in the realm of equity options. However, this is a problem that has generally affected pretty much all derivatives, regardless of the underlying asset class.
 
Quote from Martinghoul:

FF OIS = FedFunds Overnight Index Swap

Basically, PV of anything you own is determined by your very own cost of capital (the rate at which you discount future cashflows needs to be equal to the rate at which you fund yourself; otherwise, there's arbitrage). Obviously, it would be impractical if different mkt participants couldn't agree on a price of an otherwise fungible security due to different discount rates. So there's an implicit "fudge" where everyone kind of accepts the same rate (in most cases it would be driven by the exchange).

As to the rate itself, in the pre-crisis past, it didn't matter too much and everyone was happy to use LIBOR rates. The crisis did two things: a) exposed all sorts of nasty LIBOR issues; b) opened peeps' eyes to the fact that the choice of discount rate has economic significance. So now the mkt has kinda settled on a common denominator, i.e. OIS rates.

Now, as I have mentioned before, my experience is not specifically in the realm of equity options. However, this is a problem that has generally affected pretty much all derivatives, regardless of the underlying asset class.
More...

OK, now it is clearer, thanks. But the OIS sounds as a good benchmark regarding short term options, but what about an option that is expired within 2 years? or 3 years? Does also in these cases the rate which should be applied is the FF OIS (which relates to very short durations) even regarding such long periods in which interest rates may go up substantially and for which the treasury yields are much higher?
 
Quote from dragonman:

OK, now it is clearer, thanks. But the OIS sounds as a good benchmark regarding short term options, but what about an option that is expired within 2 years? or 3 years? Does also in these cases the rate which should be applied is the FF OIS (which relates to very short durations) even regarding such long periods in which interest rates may go up substantially and for which the treasury yields are much higher?
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Well, further out it would trade based on LIBOR swaps adjusted by LIBOR/Fedfund spread. The whole world now bootstrapes LIBOR swap curve using OIS discount, so it's not an issue
 
Quote from sle:

Well, further out it would trade based on LIBOR swaps adjusted by LIBOR/Fedfund spread. The whole world now bootstrapes LIBOR swap curve using OIS discount, so it's not an issue
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Can you give me a link to a reliable website that publish such long term rates (whether it is LIBOR swaps adjusted by LIBOR/Fedfund spread as you stated or anything else, I just want to see a ceratin number :) thanks
 
Bloomberg/Reuters are the only places I can think of where you can find the OIS and LIBOR/OIS basis swap quotes. Fed H.15 table has the benchmark LIBOR rates.
 
Quote from Martinghoul:

Bloomberg/Reuters are the only places I can think of where you can find the OIS and LIBOR/OIS basis swap quotes. Fed H.15 table has the benchmark LIBOR rates.
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I see a quote of 3-months LIBOR/OIS spread (which is about 15.65 regarding USD), and I didn't see any quote for a longer period. Does that mean that a box spread which is 10 points appart that expires within 2 years should be traded at about 9.98, so that the 3-months LIBOR/OIS is being applied to such box even considering it expires within 2 year and not 3 months?
 
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