Cessation of IBOR benchmarks throws up conundrums for derivatives markets

Global markets are transitioning to overnight indices which better reflect the true funding costs of the market. Alternative reference rates (ARR) such as SOFR, ESTR, TONA, SONIA and many others have been selected to replace the IBORs. ARRs are overnight index swaps (OIS) and are the rate used for overnight lending between banks.

However, the cessation of the legacy IBOR benchmarks, specifically GBP, CHF, JPY and the rapidly approaching end date for USD and now CAD, has thrown up a number of interesting conundrums for the derivatives markets, which has significantly impacted the interest rate options market.

ARRs are only backward looking and therefore have no locked in forward terms. This has had a fundamental impact on the modelling of ARR related Cap and Floors implied volatility surfaces where caplets have to be compounded.  

The ARR caplet payoff is directly related to the volatility strike and the compounded overnight fixing over the accrual period.  The final payoff is not fully known until the publication of the final rate relating to that period.

How TraditionDATA can help

Tradition Analytics have provided state-of-the-art tools which are used by our brokers globally to bootstrap and manage yield curves, vol cubes, and the valuation of all FX and IR derivatives including Interest Rate Options. Our analytical models and market assumptions are constantly reviewed and, where necessary, amended to maintain accuracy with market practice, most recently with the introduction of our ARR based IRO curves.

Our collateralization assumptions reflect the dominant market norms in each currency and in most cases, this means that only one collateralization is made available, however, in some cases, both domestic and US dollar cash collateral are available. Whether collateral is foreign or domestic, the common assumption is now that overnight cash collateral, typically derived from OIS rates, now include these alternative reference rates. The underlying overnight index can in turn be collateralized or uncollateralized depending on the market standard for the respective market and currency.

In order for us to build our new ARR implied Cap and Floor vol surfaces, Tradition Analytics have devised a conventional and practical approach, adding a positive shift to both strike and forward so that the lognormal Black model can still be used for pricing based on a representative implied vol. This approach provides a simple and logical way of applying a well-known model to low rate environments.

The TraditionDATA IRO offering includes real-time, intraday, end of day and historical pricing using the new suite of ARRs. Coverage includes ATM Swaption, OTM Swaption, ATM Cap/Floor and OTM Cap/Floor where applicable and where there is market liquidity. Implied volatilities are expressed in normal and or lognormal terms depending on the absolute levels of underlying rates and on local market norms.

In addition to expanded IRO strikes and tenors, TraditionDATA has expanded our IRO dataset to include much richer metadata which provides transparency into modelling assumptions and conventions. Traditions existing IRO content combined with our new ARR IROs are included in our standard IRO global and regional packages with no additional fees providing greater value to our customers.

Get in touch to find out more our IRO offering.