Podcast: Henrard on the remaining challenges for Libor transition

As Libor benchmarks are replaced by compounded overnight rates, the pricing and risk management of legacy contracts can become increasingly challenging.

As Marc Henrard, managing partner at MurisQ Advisory puts it, legacy vanilla swaptions have now become exotic products, thanks to a fallback approach that introduces new layers of complexity into cash-settled instruments. A swap, a simple series of multiple Libor payments, needs to be replaced by functions of overnight indexed swap (OIS) rates that account for different payment frequencies, and that is not straightforward.

The mismatch of annuity frequencies generates a convexity adjustment analogous to that found in futures 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-referencing rate products. “The bulk of it is CMS pricing. If you have CMS pricing in your library, you can change that a little bit and price those type of products,” says Herard, warning that if there isn’t such pre-existing infrastructure, the hurdle will be more challenging.

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

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

Following widespread debate over SOFR’s appropriateness as a lending benchmark, Henrard concedes the US lending market is adapting to term SOFR. The CME-published rate, which carries an explicit regulatory endorsement, is legally well defined he says, but it’s not technically a robust measure because it cannot be perfectly hedged. This problem arises from the futures-based methodology, which sees term SOFR calculated on average values realised during the day. “The Libor mechanism, fixing it at 11am, is a lot better,” says Henrard.

He finally expresses his view on the potential use of term SOFR as an input for a synthetic Libor, which could mop up tough legacy contracts not covered by US legislation. Regulators face a choice between the widely used CME rate, or an OIS-based point-in-time fixing provided by Ice Benchmark Administration. While he has doubts on its usefulness, given current derivatives trading restrictions around term SOFR, he says what matters is the underlying and its robustness in terms of replication and hedging, rather than the provider.

Index

00:00 From vanilla to exotic swaptions

06:00 Convexity adjustments

07:55 The proposed pricing methodologies

13:50 Avoiding the fallback altogether is preferable to use fallback rate models

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

18:55 Lending without credit-sensitive rates

21:40 How robust is the term SOFR methodology?

26:25 Which of the two term SOFRs should be adopted for a synthetic Libor?

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