4. Suppose practitioners learn that the British Banker’s Association (BBA) will change the panel of banks used to calculate the yen Libor. One or more of the “weaker” banks will be replaced by “stronger” banks at a future date. The issue here is not whether yen Libor will go down, as a result of the panel now being “stronger.” In fact, due to market movements, even with stronger banks in the panel, the yen Libor may in the end go up significantly. Rather, what is being anticipated is that the yen Libor should decrease in London relative to other yen fixings, such as Tibor. Thus, to benefit from such a BBA move, the market practitioner must form a position where the risks originating from market movements are eliminated and the “only” relevant variable remains the decision by the BBA.

(a) How would a trader benefit from such a change without taking on too much risk?

(b) Using cash flow diagrams, show how this can be done.

(c) In fact, show which spread FRA position can be taken. Make sure that the position is (mostly) neutral toward market movements and can be created, the only significant variable being the decision by the BBA. (From IFR, issue 1267) Traders lost money last week following the British Bankers’ Association (BBA) decision to remove one Japanese bank net from the yen Libor fixing panel. The market had been pricing in no significant changes to the panel just the day before the changes were announced. Prior to the review, a number of dealers were reported to have been short the Libor/Tibor spread by around 17 bp, through a twos into fives forward rate agreement (FRA) spread contract. This was in essence a bet that the Japanese presence on the Libor fixing panel would be maintained. When the results of the review were announced on Wednesday January 20, the spread moved out by around 5 bp to around 22 bp—leaving the dealers with mark-to-market losses. Some were also caught out by a sharp movement in the one-year yen/dollar Libor basis swap, which moved in from minus 26 bp to minus 14 bp. The problems for the dealers were caused by BBA’s decision to alter the nature of the fixing panel, which essentially resulted in one Japanese bank being removed to be replaced by a foreign bank. Bank of China, Citibank, Tokai Bank and Sakura were taken out, while Deutsche Bank, Norinchukin Bank, Rabobank and WestLB were added. The move immediately increased the overall credit quality of the grouping of banks responsible for the fixing rate. This caused the yen Libor fix—the average cost of panel banks raising funds in the yen money market—to fall by 8 bp in a single day. Dealers said that one Japanese bank was equivalent to a 5 bp lower yen Libor rate and that the removal of the Bank of China was equivalent to a 1 bp or 2 bp reduction. Away from the immediate trading losses, market reaction to the panel change was mixed. The move was welcomed by some, who claimed that the previous panel was unrepresentative of the yen cash business being done. “Most of the cash is traded in London by foreign banks. It doesn’t make sense to have half Japanese banks on the panel,” said one yen swaps dealer. He added that because of the presence of a number of Japanese banks on the panel, yen Libor rates were being pushed above where most of the active yen cash participants could fund themselves in the market. Others, however, disagreed. “It’s a domestic [Japanese] market at the end of the day. The BBA could now lose credibility in Japan,” said one US bank money markets trader. BBA officials said the selections were made by the BBA’s FX and Money Markets Advisory Panel, following private nominations and discussions with he BBA Libor Steering Group. They said the aim of the advisory panel was to ensure that the contributor panels broadly reflected the “balance of activity in the interbank deposit market.”