Why you should care about curves
Interest rate curves are something everyone in financial markets needs to care more about today.
This sounds like a bold claim. Curves are, of course, little more than a linear description of how people think interest rates are going to play out over time. And they have always underpinned the pricing for all OTC instruments. So why has it become necessary to give them more attention today? There are several reasons.
The first is that there are no consistent answers to questions around how curves are put together. Curves have evolved, rather than having been defined at a point in time. So different people have different views around the readings and intervals that are used to build them. This is important, because whatever part of banking you work in, curves impact your business. So understanding how they are put together is valuable.
Another reason is the continuing impact of the financial crash. Historically, people got their price curves from the likes of Bloomberg or Refinitiv, and took the price without question. Post 2008, there has been much more pressure on financial firms to understand how curves are put together, especially in terms of the timeframes used. Regulators want people to be sure that if something is priced against a curve, market participants understand it, have based their decision on logic and are prepared to stand behind the price if necessary.
“I used a major bank’s curve” is no longer a good enough answer, especially now there’s a tendency to fall back to using curves built by the five big trading banks. Market participants need to be able to understand and explain how the rate was arrived at.
Also, there are different curves for different reasons. For example, some are used for pure price sensitivity; others for delta. And the curves themselves can be based on different instruments – e.g. money market interest rates, bond rates, government-quoted interest rates – as a sample for what the interest rate would be in 2-5 years’ time. There’s complexity here that needs to be understood. And into longer, 20+ year time horizons, curves are interpolated based on historical data, which can cause other issues.
Pricing quality depends on curves
Finally, no matter how good your technology, the quality of your pricing is only ever as good as your curves. If you disagree with a curve and your pricing looks wrong, you need to know why. Likewise, you need to be able to resolve instances where your prices differ from your counterparty’s. In short, more curve knowledge is good for business.
So there’s a need for much more understanding around curves: but to date, there has not been a great deal of education available.
How to build your own curves
This is where our new series of guides come in. We have released three technical guides about curve construction, which explore the math and the techniques for building three different types of interest rate curve.
They help market professionals understand how curves are built and equip them to build their own curves, so they can get a better handle on pricing, risk and compliance.
If you’re ready to care about curves, take a look at our guides: