Podcast: Henrard on remaining challenges for Libor transition

As Libor benchmarks are replaced by compound overnight rates, the pricing and risk management of old contracts can become increasingly difficult.

As Marc Henrard, managing partner at MurisQ Advisory, puts it, old vanilla swaptions have now become exotics, thanks to a fallback approach that introduces new layers of complexity into cash-settled instruments. A swap, a simple series of several Libor payments, must be replaced by overnight indexed swap rate (OIS) functions that take into account different payment frequencies, and it is not simple.

The mismatch of annuity frequencies generates a convexity adjustment analogous to that found in forward contracts, constant maturity swaps (CMS) or Libor in arrears.

It is exactly from the CMS pricing toolkit that Henrard develops new pricing methodologies for OIS SEO pricing products. “The main thing is the pricing of the CMS. If you have CMS pricing in your library, you can tweak that a bit and price those kinds of products,” Herard says, warning that if there isn’t such a pre-existing infrastructure, the hurdle will be more difficult.

Perhaps counterintuitively, Henrard’s advice to financial institutions with cash-settled swaptions on their books is not to use his model, but rather to get around the problem by avoiding the fallback mechanism altogether. Quants are ultimately risk managers, he says, and should aim for the simplest and most effective solutions.

On a more positive note, he thinks the debate so far has been comprehensive and, at least from a quantitative perspective, issues with legacy products have been largely addressed.

Following widespread debate over the suitability of SOFR as a lending benchmark, Henrard admits that the US lending market is adjusting to SOFR over time. The rate published by the CME, which carries explicit regulatory approval, is legally well-defined, he says, but it is not technically a robust measure because it cannot be perfectly hedged. This problem arises from the methodology based on futures contracts, which sees the term SOFR calculated on the average values ​​realized during the day. “The Libor mechanism, setting it at 11 o’clock, is much better,” says Henrard.

He finally expresses his views on the potential use of the term SOFR as an input for a synthetic Libor, which could mop up difficult legacy contracts not covered by US law. Regulators must choose between the widely used CME rate or a point fix based on the OIS provided by the Ice Benchmark Administration. Although he has doubts about its usefulness, given the current restrictions on derivatives trading around the SOFR term, he says what matters is the underlying and its robustness in terms of replication and hedging. , rather than the supplier.

Index

00:00 From vanilla to exotic swaptions

06:00 Convexity adjustments

07:55 Proposed pricing methodologies

13:50 Avoiding fallback altogether is better than using fallback rate models

17:15 Are there any other issues with the Libor transition that have been overlooked?

18:55 Credit-sensitive interest-free loans

21:40 How robust is the term SOFR methodology?

26:25 Which of the two forward SOFRs to adopt for a synthetic Libor?

To listen to the full interview, listen to it in the player above or download it. Future podcasts in our Quantcast series will be uploaded to Risk.net. You can also visit the main page here to access all tracks, or go to the iTunes Store or Google Podcasts to listen and subscribe.

Now also available on Spotify.

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