Wednesday, 13 October 2021

ICE Swap Rate fallback: impact on swaption pricing

Sterling and dollar working groups have proposed fallback for ICE Swap Rates (ISR) based on the mechanism used for LIBOR itself. It is not possible to create a ISR's fallback coherent with the LIBOR's fallback. Or more precisely it is possible (and easy) for a quant to do so, based on the swap market globally, but it is impossible for a lawyer in a definition involving only one number published on a single screen.

The self-imposed restriction on the type of fallback available make the existence of a coherent fallback impossible. In the absence of an exactly coherent fallback, the working groups tried to provide an approximately coherent one.

The impacts of those fallback go beyond simply printing a formula on a piece of paper and have profound impacts on the valuation and risk management of existing instruments like swaptions.

In particular cash settled swaptions with collateral discounting have a triple problem:

  • Incoherent spread (delta hedge with swaps)
  • Non linear pay-off
  • ``Non-natural'' annuity, i.e. convexity adjustment

The incoherent spread was discussed by Marc in a previous blog: LIBOR transition: How to lose money, automatically!

In a forthcoming paper, we will show how those swaptions can be priced.

The one line summary of the pricing method is a change of strike in line with the non-linear rate transformation and a replication similar to the one used in CMS pricing.

Some early results have been presented in LIBOR transition workshops. A more detailed seminar related to the swaption pricing will be presented at The WBS 17th Quantitative Finance Conference.

Below we already proposed a graph that displays the non-linearity impact, the exact meaning of which will be discussed in the seminar. We will post a link to the full paper once published.


Note added 20 October 2021: A preliminary version of the results were presented at The 4th Interest Rate Reform Conference today.

Note added 20 October 2021: I have added the ICE Swap Rate fallback formulas to my open source library muRisQ-ir-models at https://github.com/marc-henrard/muRisQ-ir-models/blob/master/src/main/java/marc/henrard/murisq/pricer/generic/FallbackIsrUtils.java.

SOFR volume to 8 October 2021

Usual review of SOFR volumes. After a small increase a couple of weeks ago that lead us to ask "Is something happening?", we are back to levels below mid-July level at LCH. ISDA figures indicate that SOFR is back to less than 10% of interest rate derivatives volume.

No real progress a little bit more than two months before the expected deadline for "no more LIBOR".

Short term swaps (less than 2Y) volume is not increasing either, which is not a good indication for the development of Term SOFR rates.