Forward-looking Forward Rates: An Indicative SOFR Paradox

16 Pages Posted: 29 Jan 2021 Last revised: 23 Mar 2021

See all articles by Xi Liu

Xi Liu

FactSet Research Systems Inc.

Yudi Bai

FactSet Research Systems Inc.

Date Written: December 11, 2020

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

Suggested Citation

Liu, Xi and Bai, Yudi, Forward-looking Forward Rates: An Indicative SOFR Paradox (December 11, 2020). Available at SSRN: https://ssrn.com/abstract=3747159 or http://dx.doi.org/10.2139/ssrn.3747159

Xi Liu (Contact Author)

FactSet Research Systems Inc. ( email )

181 W Madison St
33rd Floor
Chicago, IL 60602
United States

Yudi Bai

FactSet Research Systems Inc. ( email )

601 Merritt 7, 3rd Floor
Norwalk, CT 06851
United States

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