So you’ve heard that LIBOR is going away, due to be replaced by SOFR? Well, if you’re not a regular user of interest rate swaps & swaptions (which, unless you’re an institutional-level client, is probably true), then what you really care about is how this impacts the thing you can most readily trade: Eurodollar futures. Here’s how Eurodollars are going to work after LIBOR.
I’ve dealt with the big picture details in an exhaustive post here, so this is intended more as a practitioners’ guide with a few examples.
ADVANCE WARNING
An important caveat: this is about as dry as it gets. If you’re looking for entertainment value, this blog post is the wrong spot – go check out something else. Seriously, I won’t be offended. The point of this post is more as an FAQ about how the pricing of Eurodollars works after LIBOR goes away. If that’s not your cup of tea, I totally get it. Things like this make my spouse’s eyes glaze over.
A FUTURE ON LIBOR
Still with me? Awesome.
A Eurodollar contract can really just be thought of as a future on a 3-month LIBOR rate. While it has yet to be formalized, the general understanding is that LIBOR is unlikely to exist in its current form beyond the end of 2021 (1) & is due to be replaced by an Alternative Reference Rate based off the Secured Overnight Financing Rate (SOFR).
Since SOFR is an overnight rate and LIBOR rates have a term associated with them, 3-months for the future LIBOR rate referenced by Eurodollars, there’s a methodology associated with turning that overnight rate into a term rate of 3-months. We can see what the historical LIBOR rate looks like compared to the historical 90-day compounded SOFR rate here (red circle is the blip that occurred after last wk’s repo episode).
The methodology employed takes all the overnight fixings that would make up the 3-month term & compounds them daily to arrive at an arrears setting – the exact detail behind this is shown in the appendix under “Calculation Methodology”. A “historical spread adjustment” is applied in order to true up the price for Eurodollars with the forward implied price for the SOFR compounding.
THE “HISTORICAL SPREAD ADJUSTMENT”
The details of this “historical spread adjustment” are still TBD (I’m writing this on September 25, 2019 & ISDA has a consultation out for comment that’s due back October 23), but it looks as though ISDA has settled on 2 possible methods for calculating this adjustment.
The first one involves taking the median value of a 5-year lookback (LIBOR vs compounded SOFR), and the second one involves taking the “trimmed mean” value of a 10-year lookback. There’s a lot more about these choices here: https://www.isda.org/2019/09/18/september-2019-consultation-on-final-parameters/
Details of the trimmed % are unclear at this point. But, for all intents & purposes, it looks like the ultimate value of the “spread” will be around 23-24 basis points (2): the rate on the Eurodollar being higher than the rate on the SOFR contract.
EXAMPLES:
Let’s take an example, using the September 2022 Eurodollar contract (Bloomberg ticker = EDU2 Comdty, Globex = GEU22).
Fortunately, we also have the market-implied 90-day compounded SOFR value for that period – SOFR futures exist & trade (though, at least right now, not as liquidly as Eurodollars). The equivalent SOFR future is SFRU2.
https://www.cmegroup.com/trading/interest-rates/stir/three-month-sofr.html
Using last night’s closing levels:
EDU2 = 98.66, SFRU2 = 98.89. The difference between the two? 23bps. Right where the implied “historical spread adjustment” says it should be (remember: we’re subtracting 23bps from the price = adding 23bps to the “rate”).
Another example, EDZ2 (December 2022 ED$):
Using last night’s closing levels:
EDZ2 = 98.635, SFRZ2 = 98.875. The difference between the two? 24bps. Again, pretty close to the presumed “spread adjustment”. Markets are already pricing this quite efficiently – AFTER the end of 2021.
For all intents and purposes, if you want to get a good idea of where Eurodollars are going to trade after LIBOR, take the equivalent SOFR future (otherwise known as the “co-terminous” future), and subtract 23.5bps.
Here’s a CME post on the topic for those who want more detail from the source:
https://www.cmegroup.com/education/articles-and-reports/the-shape-of-ibor-fallbacks-to-come.html
FOOTNOTES
(1) There’s a lot of debate around this. For starters, the mere act of announcing exact date of the impending demise of LIBOR has been argued to constitute an ISDA trigger event. It could then be argued that LIBOR is no longer representative, and the ISDA agreements that govern derivative trades would likely head to waterfall. Since a vast set of maturities exist for outstanding derivatives, any date that gets set in stone would orphan existing contracts further out the curve. Therefore, you’ll notice that in virtually every discussion there’s an important caveat that limits the speaker from explicitly citing an end date: “LIBOR is no longer guaranteed to exist beyond the end of 2021” is the typical wording, but you’ll notice some differences. Depending on who the speaker is (whether or not they have a very engrained interest in LIBOR remaining or LIBOR going away), there’s some artful wordsmithing. Firms like ICE & the CME have a vested interest in keeping LIBOR around. Regulators (and legal opinions issued by firms seeking to advise those on the transition) have an interest to make sure the public is aware & prepared. Be aware there are some differences – and they are likely due to the interests of the firm or individual issuing the disclaimer.
(2) While we should have a good idea of the method behind calculating the “historical spread adjustment” by the end of this year (and Bloomberg has already been selected as a vendor to publish these spreads), that doesn’t mean it can’t change. The lookback period is from whenever LIBOR goes away. So if it’s the start of 2022, then the lookback starts in 2012 for a 10-year lookback. That means we have most of (but not all) the existing values. Depending on the trimming mechanism, we might already have the value for the spread adjustment. But, if we see a very large move between now and the end of 2021 (which, seems quite likely), that “spread” could change based on how SOFR rates compound against LIBOR.
For more detail, you can use the following “worksheet” put together by ISDA (and the Brattle Group). https://www.isda.org/a/3W0TE/Excel-Model-Shell.zip
LINKS
ARRC FAQ:
https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC-faq.pdf
ISDA Fallback Consultation: https://www.isda.org/2019/09/18/september-2019-consultation-on-final-parameters/
CALCULATION METHODOLOGY
Disclosure/Disclaimers:
This material may contain indicative terms & there is no representation that any transaction could have been executed at such terms. Proposed terms are for discussion purposes only.
OTC Derivatives Risk Disclosures:
Understand clearly the terms of any OTC derivative transaction you may enter into. You should carefully review these terms with your counterparty.
Also, understand the nature of your exposure. Consequently, you should be satisfied that such transactions are appropriate. In addition, you may be required to post margin.
This post was written by me & the material is my own, except where sourced. I am not receiving compensation for it.