Sunday, 28 October 2018

LIBOR fallback transformers - forward discontinuation

In this transformer's blog installment, we look at forward starting discontinuation.

The procedure for LIBOR discontinuation refers to two dates: the announcement date and the discontinuation date. The announcement date is the date when one of the triggers is made public, e.g. the benchmark administrator announces that he will cease to provide the IBOR permanently. The discontinuation date is the date when the benchmarks discontinuation is effective. It is expected that there will be some time between the two dates. One potential scenario would be that by mid-2021, the majority of LIBOR contributors, that have agreed with the FCA to contribute up to end-2021, have the opinion that they do not trade enough interbank term deposit anymore to contribute efficiently to the process; the lack of contributor prompt the administrator to announce the discontinuation, effective 1st January 2022.

In that period between the announcement date et the discontinuation date, the existing swaps (or other IBOR derivatives) are becoming some kind of hybrids. The payments related to IBOR with fixing before the discontinuation date are still IBOR coupons while the ones with fixing after the discontinuation date are becoming some type of overnight-indexed derivatives. The exact type depends on the fallback option.

We have run this type of scenario on different books. We start with the simplest case of one swap. We use the same swap as the one we have used in the first episode (Fallback transformers - Present value and delta). The delta for the OIS benchmark fallback type is provided below.

Bucketed delta for a discontinuation date 1-Jan-2022 as viewed from 29-Aug-2018. OIS benchmark fallback option.

We have selected the OIS benchmark type to start, as for this option the fixing for LIBOR and for the adjusted RFR are on the same period. The risk is transferred from LIBOR to overnight, but is quite similar in term of tenors. We see what we would expect: the swap behave as a LIBOR swap up to end 2021 (last LIBOR fixing for this swap: 2-Dec-2021; payment date of last LIBOR: 4-Mar-2022). From there on the swap has the risk of an OIS. For all practical purposed, this is an LIBOR swap up to early 2022 combined with a forward starting OIS starting in early 2022.

For other options, some interesting behavior can be observed. For example for the Compounded Setting in Advance, the risk for the period from December 2021 to March 2022 appears twice, both in LIBOR and in overnight. The reason is that the fallback procedure fixes the payment for Mar 2022 to Jun 2022 on the compounded rate for a period before the coupon start accrual. The period Dec 2021 to Mar 2022 is used in the last LIBOR coupon and in the first overnight coupon.

Bucketed delta for a discontinuation date 1-Jan-2022 as viewed from 29-Aug-2018. Compounding setting in advance fallback option.

If we look at a portfolio level, the picture is not very different. We have a LIBOR exposure up to beginning of 2022 and only OIS exposure after that. We used that same portfolio as in the previous episode (LIBOR Fallback transformers - portfolio valuation)

Bucketed delta for a discontinuation date 1-Jan-2022 as viewed from 29-Aug-2018. Large portfolio example with OIS Benchmark option.

  1. Fallback transformers - Introduction
  2. Fallback transformers - Present value and delta
  3. Fallback transformers - Portfolio valuation
  4. Fallback transformers - Forward discontinuation
  5. Fallback transformers - Convexity adjustments
  6. Fallback transformers - magnified view on risk

Don't fallback, step forward!

Contact us for our LIBOR fallback quant solutions.