December 28, 2012
Shun Kobayashi*

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Abstract

This study, based on a search model, attempts to draw out the implications for discussions about reference rates that originated from the recent Libor manipulation scandal, with particular focus on whether the calculation of reference rates should be based solely on actual transaction data and whether the use of expert judgment should be allowed. Generally speaking, yields on financial instruments can be decomposed into elements such as risk-free rate, (credit and/or market) risk premium, and liquidity premium. The reference rate is not exceptional. In developing a model, given that in times of crisis, liquidity dried up in interbank markets where reference rates are calculated, we use a search-based asset pricing model by Duffie, Garleanu, Pedersen (2005, 2007) to consider a situation in which market transactions are sporadic. In evaluating asset prices, we also combine this model with the robust control method, a technique for incorporating model uncertainty (e.g., a situation in which market participants lose confidence in their own pricing models and market prices during crises). The results suggest a jump in the liquidity premium to the level exceeding the risk premium based on the fundamentals, while being amplified by uncertainty. Given that reference rates are broadly used in deciding lending rates for a number of financial contracts and the prices of derivatives, it may be economically inefficient to use interest rates that include premiums which have risen due to a temporary surge in uncertainty. Thus, an expert judgment could be allowed to some extent in order to remove these premiums.

JEL Classifications
G11, G12

Keywords
Reference Rate; Libor; Market Liquidity: Search Model; Robust Control.

This paper is based partly on Kobayashi, Nakamura, and Ohashi (2008). The author is grateful to the co-authors of that paper (Nobuhiro Nakamura [Hitotsubashi University] and Kazuhiko Ohashi [Hitotsubashi University]) for their advice. The author would also like to thank staff at the Bank of Japan, especially Kentaro Kikuchi, Azusa Takeyama, Kazuo Momma, Ko Nakayama, Hiromi Yamaoka, Yoshinori Nakata, and Kanako Saeki, for their helpful comments. The opinions expressed here, as well as any remaining errors, are those of the author and should not be ascribed to the Bank of Japan or the Financial Markets Department.

*	Director, Financial Markets Department E-mail : shun.kobayashi@boj.or.jp

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