The Making of Zero Curves

Risk-free rates are ubiquitous in finance, even more after the Cox-Ross [6] principle of risk-neutral valuation for derivatives. Simple arbitrage shows that they can be negative only if considered net of the storage cost of money. The phase-out of Libor, its replacement by overnight reference rates, and the way they are used to determine zero rates make this paper’s topic relevant. Similarly to the federal funds rate, which is a weighted average of the rates in brokered transactions (with weights being determined by the size of the transaction), we advocate the construction of transaction-weighted zero curves. In particular, we highlight the role of risk-free zero curves defined by the ISDA CDS standard model in order to standardize the quotes in the market for credit default swaps.