Abstract
The transition from term-based reference rates to overnight reference rates has created a dislocation in the market-making processes between the interbank and non-interbank funding, and their respective derivatives markets. This dislocation can be attributed to differences in funding and corresponding interest rate swap transactions, a thesis we explain and characterize in detail. It is then shown how this dislocation may be resolved. Based on a systemic perspective of a stylized financial system, an aggregated banking system is constructed that is void of idiosyncratic credit risks but still vulnerable to liquidity risks. Within this setup, a mathematical modeling framework for term-cognizant interest rate systems is derived that enables the pricing and valuation of bank term funding and associated derivatives transactions with varying liquidity characteristics. Other outcomes include: (i) a detailed analysis of the incomplete market paradigm that encapsulates bank term funding rates and the risk management processes involved therein; and (ii) a recovery of consistency in the pricing and valuation between funding and related interest rate swap transactions, along with a mechanism to exchange term risk.
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