Forward-looking Forward Rates: An Indicative SOFR Paradox

Abstract

The Alternative Reference Rates Committee (ARRC) has set July 2021 the goal for creating a forward-looking indicative term SOFR. In this paper we present paradoxes that will result from publishing the indicative term SOFR: complexity versus transparency of the methodology, the true risk-free rate, which bears no market, credit or operational risk, versus a market driven rate, the hedging inefficiency between cash market versus derivative market and the outcome of rising systematic risk. In light of the paradoxes, we believe that the indicative term SOFR does not possess the same economic justification as Libor, nor will it provide the necessary incentives for trading. The following sections will discuss methodology for publishing indicative term SOFR, followed by detailed discussion of the paradoxes. It is our view that these conceptual paradoxes of forward-looking term SOFR give rise to significant drawbacks in the applications, thus posing significant risk for the Libor Transition.

Keywords: IBOR replacement, RFR, SOFR, Benchmark Reform, Yield Curves, Futures, Swaps, Hedging

JEL Classification: C00; C54; G10; G12; G18