Thursday 12 March 2020

Forward looking the spread between forward looking and backward looking rates

Forward looking the spread between forward looking and backward looking rates or estimating the market misestimation 

The planned approach to adjustment spread in the new derivative LIBOR fallback arrangements are based on historical data. The spread historical data is based on one side the LIBOR forward looking rates and on the other side on the backward looking compounding setting in arrears.

This arrangement creates a spread which is a mixture of credit spread and market misestimation (see A Quant Perspective on IBOR Fallback consultation results, Section 5.2 for previous remarks on this). What is happening to that spread with the current crisis? By definition of the spread itself, we will be able to analyse this only in 3 months time, when all the overnight rates prints are known and we can compare the then backward looking overnight rate to the today forward looking LIBOR rate.

But it is possible to do a little bit better. We know the LIBOR rates over the last 3 months and we can project the overnight rates for the next 3 months. That does not really help us for the spread corresponding to today fixing, but it will help for the LIBOR fixing over the past three months. It is possible to get an estimate of the surprise (surprise cut in this case) that has already been realised.

The following graph is the result of that exercise for USD-LIBOR-3M and USD-SOFR. The LIBOR rates (dark blue line) are know up to today. The SOFR compounding rate in arrears based on the actual fixing (light gray line) are known up to the period corresponding to the fixing from 3 months ago. The projected in arrears for the 3 months up to today (dark grey) are based on known fixing up to today and projected fixing up to the end of the 3-month period. The spreads up to 3 months ago (yellow) are fully known and the spreads up to today are partly known (red) with the LIBOR side fully known and the SOFR side partly known.

We can see that the (projected) data already includes spike in the spread due to the surprise cut. The spike is above 100 bps. On the other side, for the fully forward looking LIBOR versus the fully forward looking SOFR (last red point on the graph), this is a spread without any unexpected element of monetary policy, has a spread larger than the average/median over the last years but is very far away from the spike. It does not mean that the credit crisis is suddenly seen as less severe over the last days, only that the market is not expecting unexpected policy changes.

We have done many other developments around the analysis of spread data in the context of the LIBOR fallback. This includes analysis of minimum and maximum spreads, estimations based on forward curves with calibration using spread control (see Curve calibration and LIBOR-OIS spread).

Don't hesitate to reach out to discuss how those developments could be of interest in the context of your portfolio management.