Term Risk in Interest Rate Markets

Based on a stylised financial system along with a systemic perspective thereof, we consider the structure of an aggregated banking system that is vulnerable to liquidity risks. Within this setup, a consistent mathematical modelling framework for term interest rate systems is derived that enables the pricing and valuation of associated linear derivative instruments. It is then demonstrated that term rates may not be synthetically replicated, in general, which in turn enables the extraction and explanation of the source of term risk. These findings provide: (i) a detailed analysis of the incomplete market paradigm that encapsulates inter-bank term rates and the risk management processes involved therein; and (ii) theoretical and quantitative evidence against global interest rate reforms replacing term reference rates, e.g., Libor, with alternatives based on overnight-rate benchmarks, such as Sonia and Sofr