Saturday 14 March 2020

LIBOR Fallback: a median in a crisis

The ISDA proposed LIBOR fallback mechanism is based on a 5-year historical median estimate. If the LIBOR discontinuation take place as expected in January 2022, we already have a certain portion of the required historical data.

In this analysis, to keep the number of variables low, we look only at USD-LIBOR-3M and suppose that the announcement date is 1 September 2021 (3 month before January 2022). We interpret the "5 year of history" as meaning 5 years of LIBOR fixing for which we have the relevant SOFR fixings. This means we actually use 5 years and 3 months of overnight data (other interpretation of "5 years history" are possible). The LIBOR fixing are from 29 June 2016 to 29 June 2021.

We can plot the historical data from the known period (29 June 2016 to 13 March 2020); the histogram of the data is provided below. The figure also displays the median (as per ISDA proposal) and the median (for comparison). The median is 26.6 bps and the mean 29.2 bps.

There is still the period from 16 March 2020 to 29 June 2021 which is unknown. The proposal is to use the median. We have 876 data points out of the 1260 required. We can already put a hard bound on the lowest and highest possible median spread (conditional to our date hypothesis). The lowest median possible is 20.2 bps and the highest median possible is 36.5 bps. Those figures are represented below.

What about the mean? The mean depends on the exact value of each number, and there is no a priori bound on the individual spreads, so no a priori bound on the mean either. We can nevertheless create some "what-if" analysis. For that we use two extreme scenarios: one with all the remaining spreads at 0 bps and one with all the remaining spread at 100 bps. The graph of those values is proposed below.

The different daily spreads are not independent. There is significant overlap between the overnight rates used in consecutive daily spreads. The spreads tend to cluster, creating a trend in the median evolution. Where are we today (or more exactly were are we in the combination of LIBOR from 3 months ago and overnight up to today)? In the figure below, the have colour-coded the different occurrences. The lighter colours represent the more recent ones, each colour representing one of the 8 groups of 10 prints (a total of 80 recent print are in lighter colours).

The trend in the last months has been to be higher that the median. Note that the above figure do not include the LIBOR rates from the recent turbulent weeks; those will appear in the statistics only in a couple of months. Our best predication of those (see our recent post on Forward looking the spread between forward looking and backward looking rates) is that there will soon be very high spreads (above 100 bps).

This lead us to an embedded option in the fallback proposal. We mention our best estimate of the spreads in the coming months. Suppose that our estimation is perfect, are we sure that those spread will be included in the actual spread computation? The computation of the spread will be done on the announcement date (not on the cessation date). The announcement date will be decided by IBA and the panel banks, the procedure is thus giving a (free) option to the panel banks. Even disregarding the potential material nonpublic information embedded in the decision, there is a real option of non negligible value. Suppose that the option is exercised today and the announcement is made today (for an actual cessation in January 2022), what would be the impact? It is graphically depicted in the figure below. The direct impact would be an estimated margin of 24.5 bps, which is a decrease of 2 bps with respect to the first estimate in this post. Maybe more importantly it also removes the possibility of the spread going up to 36.5 bps which would be the case if all (market) spreads in the next 2 years or so were to be above 36.5 bps. The announcement option has a potential value of as much as 12 bps on all transactions with fixings post January 2022.

What are your options with regards to the fallback and how do you plan to exercise them? Don't hesitate to contact us to estimate them.

We have done many other developments around the analysis of spread data in the context of the LIBOR fallback. This includes analysis of value transfer impacts, forward spreads, 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 the management of your portfolio.