global model risk incurred by the LIBOR transition
by Patrick Toolis At first glance, the interest-rate migration away from the London Interbank Offered Rate (LIBOR), which is scheduled to begin by December 2021 in the United States and the United Kingdom, is little more than a market-data issue1. Rates such as three-month LIBOR will be replaced by their equivalents in SOFR, SONIA, etc, depending on the currency involved2,3,9,10. However, the revised underlying instruments, calculation methods, and collateralization underlying the rates means that the levels of these interest rates may deviate from those of comparable LIBOR. In addition, uncertainty about which new reference rate is the standard for a given tenor and the lack of established derivatives products based on the new rates may introduce both new arbitrage opportunities and interest-rate risk. Lastly, the operational overhead of modifying existing derivatives contracts which will still be in effect during the rollover such that the contractual term LIBOR can be replaced with some permutation of the new reference rate and a spread may be non-trivial. While these changes to the current trading workflow pose several risks, the model risk induced by creating models taking as input reference rates which did not exist during the time periods spanned by historical training data sets may be a more substantial long-term danger.
new overnight benchmark risk-free rates SOFR (United States) SOFR is an acronym meaning Secured Overnight Financing Rate and is an average of interest rates paid on US Treasury repurchase agreements2,4. This standard was proposed as a replacement for LIBOR in 2017 by the Alternative Reference Rates Committee of the US Federal Reserve Bank. It is published daily by the US Federal Reserve Bank of New York 2. This rate is used, along with the longestablished US Effective Federal Funds Rate, as the reference rate for overnight index swaps (OIS)2,8. SONIA (United Kingdom) This acronym stands for Sterling Overnight Index Average, a benchmark published by the Bank of England (BOE). It represents an average of rates used in unsecured sterling overnight interbank loans reported to the central bank. The BOE estimates that about thirty trillion GBP in assets are valued using SONIA annually, and Wikipedia indicates that about twenty-one percent of the floating rate bond market referenced SONIA in 20189,10. 004
Intelligent Risk - April 2020
