A Consistent Framework for Modelling Basis Spreads in Tenor Swaps

The phenomenon of the frequency basis (i.e. a spread applied to one leg of a swap to exchange one floating interest rate for another of a di fferent tenor in the same currency) contradicts textbook no-arbitrage conditions and has become an important feature of interest rate markets since the beginning of the Global Financial Crisis (GFC) in 2008. Empirically, the basis spread cannot be explained by transaction costs alone, and therefore must be due to a new perception by the market of risks involved in the execution of textbook "arbitrage" strategies. This has led practitioners to adopt a pragmatic "multi-curve" approach to interest rate modelling, which leads to a proliferation of term structures, one for each tenor. We take a more fundamental approach and explicitly model liquidity risk as the driver of basis spreads, reducing the dimensionality of the market for the frequency basis from observed spread term structures for every frequency pair down to term structures of two factors characterising liquidity risk. To this end, we use an intensity model to describe the arrival time of (possibly stochastic) liquidity shocks with a Cox Process. The model parameters are calibrated to quoted market data on basis spreads, and the improving stability of the calibration suggests that the basis swap market has matured since the turmoil of the GFC