The nature of premium illusion in finance – Part I
Over the past three months I’ve devoted blog space to describing the nature and benefits of robust frameworks in the financial markets context. Changing tack from frameworks to a related issue, I’m going to write a series of blogs that examine an issue that those faced with market risk decision-making may not realise they encounter: the problem of premium illusion.
In doing so, I’m going to attempt to show that premium illusion is quite real, and why it can be a serial problem for those whose hedging frameworks exclude the use of option-based products.
To make these pieces more digestible I’m going to look at three simple cases that to me exemplify the problem, starting with the extended period of seemingly forever falling interest rates in the Australian interest rate markets. I want to stress up front that I chose, ex-ante, the Australian short-end rate market before I conducted any tests for actual evidence of premium illusion.
Falling rate persistency
As of this blog’s publication it is 4,131 days since the Reserve Bank of Australia last moved to raise the RBA Official Cash rate. That is, official rates have moved ratchet-style in only one direction for more than eleven years.
Mirroring these official moves, key interest-rate (IR) markets have moved in generalised lock-step with the prevailing cash rate, albeit with the kind of advance-and-lag process experienced dealers will be familiar with. This includes the recent heightened expectation of looming cash rate rises.
For all intents and purposes rates have been a one-way ‘bet’ for at least nine of the past ten years, and up until quite recently it has only rarely paid to hold outright paid-fixed IR-derivative positions.
For those tasked with interest-rate hedging, traditional IR- Swap programs that seek opportunities to fix forward rates have proved a burden throughout the seemingly never-ending decline in yields.
How can we be certain?
Here I will leave aside comparisons of floating-reset realised rates versus comparable spot-starting IR-Swaps for like tenors. This is because the nature of ultra-low short-term yield curves in the relevant period makes this a wholly unfair comparison.
Instead, I will look at realised rates of 1-Year into 1-Year (1y1y) forward-starting swaps versus comparable spot swap rates at each forward start date going back ten years.
Terminal Payoffs
Consider the case of a treasury dealer who has been required to periodically lock-in forward IR hedges via paid AUD 1y1y IR-Swaps.
Acknowledging that this is analysis by hindsight, it is still instructive to ask: how did this simple 1y1y forward hedging strategy perform against doing nothing (then swapping fixed via vanilla spot-swaps)?
The answer is, not well at all; the fall in rates was simply too persistent for forward paying to be of benefit.
Of 2,363 observed AUD 1y1y paid swaps, the realised outcomes since 1st February 2012 were:
In other words: 87.8% of the time the 1y1y forward rate paid exceeded the eventual 1y spot swap.
To summarise: IR-Swap hedging programs designed to periodically fix borrowing rates proved overwhelmingly costly versus simply doing nothing in the past ten years.
There was a persistent realised premium associated with forward hedging when we apply the following simple formula to the historic data:
What of comparable 1y1y payers swaptions?
For those unfamiliar with swaptions, an IR-Swaption is simply an option that gives the holder (i.e., the buyer) the right but not the obligation to enter into either a paid-fixed, or received-fixed IR-Swap (or a cash settlement amount equivalent to the intrinsic value of the swaption at the moment of expiry).
For all intents and purposes, swaptions markets operate like any other market for options, and OTC swaptions in major derivatives trade in $ trillions each year. They are quite liquid.
The standard pay-off for a swaption is quite similar to other such instruments.
For the purposes of display, I’ve created a hypothetical 1y1y PAYERS Swaption whose attributes I’ve made up from the rounded-up averages of available market data (May 2013, to the present):
Expiry: 1-Year
Underlying Swap: 1-Year Swap
Strike: 1.60%, i.e., at-the-money (ATM)
Premium: 0.45%
The counterintuitive
Having been involved in various options markets for many years I’m convinced that standard option “pay-off” diagrams that adorn the texts have served to mislead those who might otherwise use them as hedging instruments. In part, this has led to a chronic misunderstanding of the reason one should consider using option-based products when circumstances might make such consideration reasonable
Why?
Somewhat counterintuitively, the main benefit of option products when deployed as hedging instruments (not as expressions of trading views) is actually when the market moves against the prevailing strike, i.e., when the option FAILS to pay off.
Payoff diagrams serve to encourage the view that option buyers benefit only when the option moves in the direction favourable to the strike, but here I urge readers to think in terms of relative realised costs compared to fixed-rate alternatives.
Taking the example of our 1.60% PAYERS Swaptions, consider that:
1. If rates rise, the swaption protects the borrower at 1.60% for 0.45%, for an effective all-in swap of 2.05% fixed – the swaption can at no point ‘beat’ a paid-fixed swap at rates above the swaption strike price.
2. If rates fall, the borrower holds the option to let the swaption lapse and PAY swap rates at favourable levels (and if rates fall very quickly the borrower might PAY on swap at a favourable moment and sell back the swaption for whatever extrinsic value as can be recouped).
Point 2 almost perfectly describes the latitude the swaption actually provides which theoreticians call: intertemporal choice, which is a rather fancy concept that means the holder has time to pick a more favourable rate if one emerges. It describes the value of time in options products, affording holders freedom to choose favourably among given market states.
This is a long-underappreciated feature of option-based products, and associated strategies.
The 1y1y PAYERS Swaption versus 1y1y PAID Swap?
Over the slightly shorter 2,037 trading days (7 years, 9 months) for which we have swaption pay-off data what should be clear is that the swaptions performed similarly poorly to outright swaps. The rate markets rallied; rates went down throughout, both PAID Swaps and PAYERS Swaptions lost money outright.
But what about relative outcomes?
It turns out that PAYERS Swaptions outperformed PAID swaps with a not inconsiderable frequency:
To clarify
Let me pause here to recap and clarify what the data is telling us:
1. In the prevailing interest rate environment since 2012 forward IR hedges of all types proved costly,
2. Hedges proved costly almost 90% of the time (87.8% in the 1y1y)
3. The average hedging cost was 45.6 BP worse than doing nothing.
4. The alternative of PAYER Swaption hedges would have reduced this cost around 40% of the time – and likely more (given intertemporal choice), had they been used in place of PAID IR-Swaps.
It’s important to note that I’m comparing relative terminal outcomes between competing products, not expressing a view of outright gains or losses, nor am I seeking to push a product bias. As we will see in my next blog, there have been times when option-based hedges have been serially wasteful.
For those who maintained a hedge program, there are questions that could be asked:
§ Could deeper product appreciation of the potential benefits of optionality be deployed to your advantage?
§ Have you developed an approach to assessing whether fixed or options-based products are better tailored to your view or the prevailing environment?
How can we tell there is premium illusion?
In the market history I selected for this case study (1y1y AUD forwards, selected ex-ante) it’s clear that swaptions created opportunities for better hedge rates for vanilla swaps with good strong frequency, but I should concede I had an advantage in selecting the data, having traded my first option in 1989. The persistent fall in rates is a classic case for use of option-based hedges in preference to fixed hedges, and of course I knew this.
Yet, despite the 38.1% edge we find in the historic data, and the fact that option-based hedging instruments were clearly better tailored to a prevailing rate-environment, it’s not clear that the advantages hidden away behind pay-off diagrams are well known in the wider financial markets community.
So, I ask this question: if option-based hedges can be shown to be valid market instruments, why are they so infrequently used in hedging interest rate risk?
We know from long experience, from Depository Trust & Clearing Corporation (DTCC) data, and from elsewhere, that the use of options as hedges is dwarfed by fixed hedges across almost all markets.
The BIS data shows the poor take-up of option products emphatically:
Proportional market use by product-types:
Source: BIS
To our knowledge the use of interest-rate-options in global financial markets has at no time been above 10% of total USD derivative product usage, and in some jurisdictions the usage has been even lower. Worse, in our recent experience we have seen nothing to suggest any higher degree of interest in IR-Option hedges across markets, despite the volatility associated with COVID-19 and heightened uncertainty.
Which suggests there is something fundamental which deters people from deploying these products.
There are many possible factors at play here, some of which I will explore in a follow-up blog; but to my mind premium illusion or premium-aversion is very real, and at play. It alone probably explains the lion’s share of why market participants are so reluctant to actively consider options-based hedges.
As I believe this select example has shown it can be demonstrated that a lack of robust product understanding can really detract from hedging performance.
It simply doesn’t need to.
Cross currency basics 4 – Uses for buy-side and complex pricing
This is the fourth instalment of my series in cross-currency swaps. Previous articles have covered the basics, looked at some pricing aspects and the revaluation challenges brought about by changing conventions. This time I move to some of the uses for cross-currency swaps and how the trades are structured and priced.
Many buy-side participants in the market are looking to hedge real risks and/or move exposures or capital from one currency to another. The final price is often built from several markets and the outcome may be confusing or opaque. The inputs can use different reference rates such as SOFR or LIBOR, have 3, 6 or 12-month floating refixes and settlements and many other variants.
All this can be complex to price and understand when looking at a transaction.
This blog looks at some examples of commonly used cross currency-swaps and how some of the inputs to the pricing are used to build a final product.
Fixed to floating cross-currency
A very common trade is related to debt instrument issued in one currency with the proceeds to be used in another currency. An example is where an Australian issuer taps the USD debt markets with a fixed rate debt issue and wishes to use the proceeds for activities in AUD. The size of Australia’s considerable capital flows makes this trade a vital component of the financial system.
Another example is a French issuer also tapping the USD debt markets and swapping the proceeds back to EUR.
The outcomes are quite interesting and offer some insights to the pricing.
5-year USD fixed rate debt issue by Australian firm looking for AUD BBSW
In this example, the inputs and pricing approach is as follows:
Fixed rate debt is issued with yield 3.00% semi fixed coupons
USD IRS (semi 30/360 against 3-month LIBOR) with yield 2.00%
Calculate the LIBOR spread, SL = 300 – 200 = 100 bps
USD LIBOR to 3-month SOFR with spread 23 bps
Calculate the SOFR spread, SF = 100 + 23 = 123 bps
USD SOFR to AUD BBSW 3-month with spread 9.625 bps
Calculate the AUD BBSW spread, SA = 132.625 bps
As we can see, the number of pricing inputs and calculations is substantial, but the simple math works out ok.
However, this calculation ignores any convexity impacts. The correct price is actually SA = 133.625 bps which is 1 basis point higher because AUD interest rates are higher than USD interest rates and the convexity effect increases the spread.
Of course, points 2 -5 can be changed if the SOFR IRS is used instead of the LIBOR IRS. But remember that the SOFR OIS is typically quoted with annual fixed coupons which will also have to be adjusted to semi-annual 30/360 for the pricing to calculate SF.
5-year USD fixed rate debt issue by French firm looking for EUR Euribor
This example is quite similar to the AUD version except an additional basis market (€STR versus Euribor) is included:
Fixed rate debt is issued with yield 3.00% semi fixed coupons
USD IRS (semi 30/360 against 3-month LIBOR) with yield 2.00%
Calculate the LIBOR spread, SL = 300 – 200 = 100 bps
USD LIBOR to 3-month SOFR with spread 23 bps
Calculate the SOFR spread, SF = 100 + 23 = 123 bps
USD SOFR to EUR €STR with spread -20 bps
Calculate the EUR €STR spread S€ = 103 bps
EU €STR to Euribor with spread 16.20 bps
Calculate the EUR Euribor spread SE = 86.80 bps
As we can see, the number of pricing inputs and calculations have increased but the simple math still works out ok. Note also that we had to add points 8 and 9 because the USD/EUR cross-currency is quoted as SOFR/€STR and we are looking for the relevant spread to Euribor.
This calculation again ignores any convexity impacts. The correct price is actually SE = 78.10 bps which is 7.7 basis points lower because EUR interest rates are lower than USD interest rates and the convexity effect reduces the spread.
Implications for buy-side users
The number and complexity of the pricing inputs coupled with convexity impacts can make the whole process quite cumbersome and complex.
Market quotation conventions and inputs can vary across currencies and can sometimes be quite challenging to discover. Even small changes to conventions can make significant changes to the price.
As I mentioned in the previous blog, booking and valuation systems are also challenging for many users. The cross-currency trade you book will have to be revalued at some time and the inputs required to reconstruct to price are the same as the original inputs. All of these must be carefully defined in systems if you are to avoid valuation disasters.
Summary
I highly recommend all users fully understand the inputs to the pricing and at least perform a ‘back-of-the-envelope’ calculation to get an initial price check similar to the steps above. But nothing replaces a full pricing process which will adjust correctly for all conventions and convexity impacts.
An accurate price at inception is essential and it has to be supported through the life of the transaction for any amendments and valuations in systems and processes.
The possible uses for Term Risk Free Rates (RFRs) and credit-sensitive reference rates such as Ameribor and BSBY will be covered in a future blog. While these reference rates are not widely used at present, there is considerable interest from buy-sude users as they may be a better fit than compounded RFRs for them.
Martialis is actively supporting our clients in pricing generally and cross-currency in particular. We see these issues regularly but they quite solvable with some dedicated assistance.
That’s not a framework…
At Martialis, we routinely advise in situations where an absence or the presence of adequate frameworks has led to problems that client firms might otherwise have avoided; which explains our somewhat obsessional interest in promoting frameworks.
Obsessions aside, we do not suggest every minor firm issue needs a framework -far from it. But those that feature prominently in firm outcomes, particularly where issues may undermine the outcomes for firm shareholders, should be considered (if nothing else).
In this blog I venture into listing the attributes of what we believe constitute healthy frameworks, sharing the collected Martialis house view. It’s not the work of academia or a collection of on-line material, rather it is our experience of how solid framework brings positive results.
I start with an example of a framework which has stood the test of time.
An example of solid frameworks - Ray Dalio
Connecticut based, Bridgewater Associates is one of the world’s largest and most successful hedge fund managers. With circa U$150 billion under management, in certain size categories it would be considered the world’s largest, just as in certain return-series the firm’s returns have been simply Buffet-like, astounding.
Founded in a Manhattan apartment in 1975, Bridgewater has been a success at almost everything it has touched; from consulting, to research, and through to money management (particularly), and many readers will associate the firm with its founder and inspirational leader, Ray Dalio.
Aside from the many successes of Bridgewater, one of the things that singles the firm out as unique is Dalio’s preparedness to spread his view of how to build a great business (or great anything really).
He does this by promoting access to the firms Principles: Life and Work, which has been variously turned into:
Having read the earliest versions of Dalio’s work (in its initial e-book stage), like so many of my peers in financial markets I wanted to get a feel for how the Bridgewater founder thought; what was his firm’s recipe for success? At a mind-numbing list of actual principles (I haven’t counted them, but the condensed version lists 157), I love so many aspects of the list, but I’m not sure they can easily be lived by, and Dalio himself doesn’t suggest one actually try.
In making a point about Ray Dalio in a work exploring the importance of frameworks, readers should note that Principles mentions ‘framework(s)’ literally only three times. This might present as strange, but the reason for this is simple: Ray Dalio actually considers his work a framework in its own right, noting eventually (see page 315) that Principles is: “a framework you can modify to suit your needs (Principles: Life and Work, Ray Dalio, Simon & Schuster, New York, Page 315).
Which is my point.
Bridgewater’s success is well known to be the result of the firm’s leadership embracing Dalio’s Principles as their overarching framework. A framework that guides how people operate within the firm, not necessarily as we might infer, some codified system of rules and/or controls that manage specific matters.
The key is that Bridgewater has an amazing high-level framework that guides staff when they make decisions; witness the quite staggering compound benefits.
Principles or Frameworks?
One could easily argue all day about what constitutes a principle and what constitutes a framework. The two concepts are obviously related, though subtly different, but we believe they play important and somewhat different roles at different points in the hierarchy of firm management and control.
And the difference, subtle or otherwise, should not be dismissed.
Taking the Oxford Dictionary definitions in turn:
Principle: a moral rule or a strong belief that influences your actions
Framework: a set of beliefs, ideas or rules that is used as the basis for making judgements, decisions, etc.
Perhaps the best way to explain the difference is by resorting to the example of the founding of the United States as an independent nation.
The framers of the US constitution settled on a set of five guiding principles for the system of government they wanted to establish; which included: federalism, limited government, popular sovereignty, republicanism, with checks and balances.
These were enshrined throughout the Constitution that was eventually crafted, and it – The Constitution for the United States - became the crucial written framework for how the US form of government would work.
At Martialis, we believe that in a firm-management context it is this latter distinct and crucial difference between principles and frameworks that matters when it comes to how best to order firm workings:
Principles provide high-level guidance with respect firm directions and values
Frameworks establish rules-based structures in particular areas, circumstances, and where enterprise risks are present
Which brings us to the question of what constitutes a healthy framework?
Principles of Healthy Frameworks
In formulating the following, we naturally lean towards our experience within financial markets. However, we believe in most cases these could be applied to firms in almost any industry setting.
There are seven Martialis principles for healthy frameworks, in what is still for us a work in progress:
Principle 1 - Tailored for Task
Individual frameworks should be tailored for the specific circumstance, task, objective, or risk the firm wishes to manage or control; no more, no less.
The degree of tailoring is theoretically limitless, but we believe should be calibrated based on relevant elements such as:
Degree of subject-matter complexity
Degree of prescriptiveness desired
Formality, for example: guidance versus policy
In financial-market risk, macro-economic factors and correlations should also be considered and/or formally assessed when tailoring.
In assisting clients in a range of subject-matter, we are often tasked with cross-reference reviews into firm frameworks. In this we often note that elements of quite workable frameworks sit in disparate fragments, while others can be beautifully crafted and perfectly concise, while sitting hidden in tome-like volumes. We therefore recommend that any individual framework be tailored in ways that avoid fragmentation or the risk of the work becoming submerged (out of sight, out of mind).
Principle 2 - Designed to avoid reactive decision-making
Reactive decision-making can be argued to invite randomness into firm outcomes, particularly in financial-market risk settings. Ensuring a framework minimises reactive decision-making is crucial.
It’s important to note that for Martialis, we believe this should apply on both sides of firm outcomes, avoiding reactivity across different states, such as:
When markets deliver unfavourable conditions,
When market conditions are favourable,
When market conditions are stable/unremarkable
I note that very few of the frameworks we have encountered have any definition of what might be done when market conditions present opportunities.
In my most recent blog I recounted the story of a firm that had a ‘do-nothing’ framework based on a buffer-rate, while maintaining a significant (actually existential) firm sensitivity to an exchange rate. This unfortunately ensured that when currency market conditions favourable to the setting of longer-term risk hedges were reached the firm continued to do nothing.
In our view firms who seek to manage outcomes need to be mindful of the practical impact of the framework at both ends of the risk continuum, not simply on one side. In favourable circumstances rainy-day hedges can prove highly beneficial. Frameworks should encourage latitude to manage the upside as well as the downside.
Principle 3 - Accountabilities should be clearly defined
Where decision-making accountabilities are involved unambiguous accountabilities as to delegated authority are vital, and ideally formally maintained. This includes decision-making forums, particularly where a quorum is needed before time-sensitive decision making is prevalent.
Who is delegated to make a decision?
Who can make the decision in the event they cannot?
To whom is the decision-maker responsible, and to whom can a decision be escalated?
On what basis can they make their decision? E.g., do they require formal advice?
What is the boundary on the extent of their decision-making delegation?
What decision-making artefacts should be preserved once a decision is taken?
We mentioned in Principle 2, that reactive decision-making invites randomness into firm outcomes. This is often due to the fact that key decisions are often forced upon firms in time-sensitive settings, particularly where financial market risk is concerned. It is also the case that risk-reward asymmetry can play a role (a topic for a future blog, but losses are psychologically different to gains). Healthy frameworks are those devised to minimise decision-making ambiguity in all its guises’.
Put another way: ambiguity invites eventual disaster.
Principle 4 - Thresholds should be thoughtfully calibrated and consequential
Where circumstances demand the imposition of framework thresholds, for example in areas of stopping risk or losses, it’s important that the thresholds themselves be:
Carefully considered (and maintained on an ongoing basis where appropriate)
Respected
Monitored
Policed if necessary
This remains the case regardless of the decision-making latitude afforded to key staff.
Our firm has deep experience in managing teams in various financial markets settings, including settings which afforded key-staff quite generous decision-making latitude. It’s important to note that in these settings robust frameworks were not devised to prevent active management of financial risk, but quite the opposite.
Well thought out thresholds, for example: well thought-out loss tolerances, can promote good decision-making, but only if thresholds set and agreed are meaningfully policed.
Principle 5 - A framework should be formally recorded
Lack of formal recording of frameworks, particularly risk-bearing elements such as delegations and authorities can be as dangerous as the absence of a proper framework. We recommend a reasonable degree of formality be associated with the task, and proper recording is not difficult once a framework has been tailored and agreed upon.
Proper recording has many associated benefits, not limited to:
·Minimising confusion and downstream dispute
Ensuring stakeholder awareness
Facilitating appropriate 2nd/3rd line ex-post review
As a record of decisions-taken,
As mentioned in my last blog, the absence of formal record keeping of firm policies can present as a weakness of governance where firms are targeted in acquisitions.
Here I will simply remind readers of our standard refrain: If it’s not written down, it doesn’t exist.
Principle 6 - Good frameworks are memorable, and readily accessible
Overly complex frameworks and/or frameworks that are inaccessible in normal conditions to reasonably well-informed staff should be avoided.
In Martialis experience, illogical or overly complex frameworks can be self-defeating and open firms to dispute and/or policy non-adherence. Where framework records are poorly kept or buried within excessively large policy manuals similar problems can arise.
Logical, internally consistent, and easily understood policies that can be retrieved from internal firm libraries should be thought of as good practice that promotes framework effectiveness.
It was the highly regarded Austrian-American management consultant and educator, the late Peter Drucker, who coined the phrase: “what gets measured gets managed.” We’re not as certain of Drucker’s claim in the age of big data, but we do agree with the thrust and suggest firms consider what happens when things that can and should be managed are poorly managed.
Our experience suggests that if staff can’t give a reasonable elevator pitch about a particular topic, they either don’t understand it, or they aren’t aware of it. The same is true of frameworks. Well calibrated frameworks with appropriate thresholds that are readily retained by key staff are more likely to be deployed when circumstances demand they be deployed; not left open to the vagaries of chance or random outcomes.
Principle 7 - Good frameworks are memorable, and readily accessible
We believe frameworks should be subject to ongoing review, particularly in situations where market circumstances can change rapidly. Markets and economies are constantly evolving, hence frameworks judiciously formed in one setting can be found wanting, or even inappropriate.
This does not mean that the tempo of review has to be disruptive, nor onerous, but a degree of regularity can be expected to pay dividends.
We note that firms that review policies and procedures keep their frameworks current, and the simple process of review can lead to improvements not recognised at framework inception.
There are few elements of business that couldn’t benefit from a commitment to ongoing review. For firms in financial markets the post-GFC regulatory environment has turbo-charged the extent of necessary policy and compliance standards that firm policy-libraries are now basically overflowing.
But this is not likely to change; which means adaptation is key.
We believe that firms who accept the realities of ongoing review and adapt to the environment stand a better chance of negotiating future risks, and of maintaining the operational poise to gain from future opportunities.
Thus, well laid policies and protocols, modern and judiciously maintained, have an intrinsic value far beyond the costs of production and ongoing maintenance, and a regular tempo of review only adds to that value.
A tedious topic?
The topic is tedious, certainly; but should it be ignored?
We intend to write more on frameworks in coming blogs, which is something of a measure of how much emphasis we believe firms should place on their proper formation: making them and keeping them fit-for-purpose.
In the context of the risk-bounty found in financial markets, I will leave you with a simple quote from Ray Dalio, explaining his personal success in his 2019 CBS 60-Minutes expose.
Ray Dalio: “It’s 100% in those principles, in other words, principles are like, um, when you’re in a situation, what choices should you make? “
Cross currency basics 3 - Pricing and Revaluation Rate Sources
On 5 and 19 January 2022 I posted blogs looking at the basic features and some pricing examples of cross-currency markets. The focus was on the ways in which end users of cross currency swaps price and transact in the markets. In many cases, the concepts can be complex to understand, and the pricing can be difficult to unravel.
Many users are currently experiencing significant revaluation issues as the markets change from using USD LIBOR to USD SOFR as the basis for pricing. Screens and data sources are often unclear on which reference rate is being used. Pages and tickers that may have been sourced for many years have changed their reference rates which can cause disruption in the revaluation process. This can lead to differences in collateral requirements and accounting entries.
This blog looks at several currencies where the connection between the Risk-Free Rate (RFR) and LIBOR versions of the cross-currency market quotes may be less than clear. As the reference rates and market conventions change then what you see on a screen can also change.
Current market conventions
Cross-currency market quotes were, until late 2021, quoted against USD LIBOR and the currency IBOR. The ‘SOFR First’ effort of late 2021 encouraged cross-currency markets in the LIBORs to move to RFRs in late September 2021 and other, non-LIBOR currencies in December 2021. Now (February 2022), cross-currency swaps are commonly referenced to USD SOFR and the currency RFR.
Examples are:
Up to late 2021 Current
EUR/USD LIBOR/Euribor SOFR/€STR
GBP/USD LIBOR/LIBOR SOFR/SONIA
JPY/USD LIBOR/LIBOR SOFR/TONA
AUD/USD LIBOR/BBSW SOFR/BBSW
CAD/USD LIBOR/CDOR SOFR/CDOR and SOFR/CORRA
The two standouts are AUD and CAD.
In the AUD case, the markets currently adopt a mis-match approach with the AUD leg continuing with BBSW rather than AONIA (RFR).
CAD is quoting both CDOR and CORRA (RFR) but has announced the discontinuation of CDOR so I expect CORRA to prevail in the near future.
Other markets have local IBORs still being used mainly because of a lack of viable RFRs.
Pricing differences
How do the new quotes appear relative to the old versions? The following table might help with examples for the 5-year cross currency (XCCY) swaps. It shows the actual quotes for cross-currency trades and the LIBOR rates derived from the quotes and the relevant IBOR/RFR basis swaps.
Firstly a few key notes:
The IBOR/RFR spread for GBP and JPY is fixed since the LIBOR pre-cessation announcement on 5 March 2021
Other IBOR/RFR spreads are market rates
The quoted rate does differ (column 4) from the derived rate (column 6) particularly in the JPY/USD. I suspect the market quotes are using a simple calculation (i.e., subtracting the currency IBOR/RFR from the SOFR/LIBOR spread) and perhaps do not fully adjust for convexity. This will make a larger difference in JPY due to the interest rate differential between JPY and USD.
Quote implications for users
When you price a new trade or revalue an existing trade, it is essential you understand the quote basis of your price. The quote difference (column 5) shows how much the quotes can differ between the LIBOR (column 4) and RFR (column 2) versions.
In several cases, the actual reference rates are not clear in the screen quotes which can make the process of using the correct basis somewhat challenging for some users. Certainly, we have seen this when advising our clients.
System implications for users
Booking and valuation systems are also challenging for many users. If the quotes are using different reference rates to your trades, then they must be correctly transformed into the ones required. For example, if your trade is USD LIBOR/ Euribor and the quoted price is SOFR/€STR then your system will need some additional basis swaps, SOFR/LIBOR and €STR/Euribor, and the algorithm to incorporate them into the valuations to make all this work.
In many cases, systems are simply unable to use multiple basis swaps because they have not been updated with the required patches. When this situation occurs, the calculations must be performed ex-system and the required cross-currency basis swaps (e.g., LIBOR/Euribor) then used for revaluation.
This is a complex, manual process but cannot be avoided if the system cannot manage the new quotes.
Summary
Moving from the LIBOR/IBOR cross-currency market quotes to the new quotes has been a challenging process for many users.
Many quotes are now based on SOFR but many trades still reference USD LIBOR, at least until 30 June 2023. Some quotes use the currency RFR while others use the existing IBOR (AUD). Some are in the process of moving from the currency IBOR to the RFR (CAD).
It is essential to get the pricing and revaluations correct to ensure the accounting entries are accurate and collateral calculations, where required, will align with those of the counterparty.
Systems for pricing and recording cross-currency swaps often need to be updated. Where this is not possible, then some calculations will have to be done outside the system and the required rates then entered into your system in a second step.
Martialis is actively supporting our clients in this effort. We are seeing quite a few challenges, but careful analysis and planning can make the transition to new cross-currency markets and quotes a little less painful.