Adapting Interest Rate Option Models from LIBOR to SOFR

Summary

The document addresses whether standard interest rate option models remain useful as markets move away from LIBOR toward SOFR. Its answer is that SABR and LIBOR Market Model approaches are expected to continue in modified forms, rather than being abandoned outright. The change requires adapting model dynamics to the conventions and structure of risk-free-rate products, including options on backward-looking compounded rates.

The response points readers toward research on SABR smiles for risk-free-rate caplets and frameworks that replace LIBOR term rates with backward-looking rates. It also identifies the Forward Market Model as a related framework for modeling these rates. This is a brief directional answer rather than a detailed account of calibration, implementation, or comparative model performance, so it does not establish a single new market standard or show empirical evidence that one approach dominates.

Key ideas

• SABR and LMM-style approaches can continue in modified forms for SOFR markets.
• Model dynamics must account for the conventions of risk-free rates and backward-looking compounded rates.
• The Forward Market Model is presented as a framework for term rates replacing LIBOR.
• The document offers research leads but no detailed implementation guidance or evidence of a dominant standard.

Tags

# What is the market standard for IR option pricing when moving to SOFR


# What is the market standard for IR option pricing when moving to SOFR












From books it looks like market standards to price IR options, like swaptions, are SABR, LMM or mix of the two (SABR-LMM). But LMM models the forward LIBOR rate. What will happen to it once LIBOR ceases to exists and only SOFR is traded in the market? Will this model still be valid somehow? Since SOFR is already here, is a new trend emerging when it comes to option pricing that might already suggest what will become the new market standard to price IR options?

## Answer by Hasek (score 8, accepted)

https://quant.stackexchange.com/a/71603

The industry will continue to use SABR and LMM, although in slightly modified versions. You may want to check the following papers to see how the extended model dynamics look like: SABR smiles for RFR caplets, Looking Forward to Backward-Looking Rates: A Modeling Framework for Term Rates Replacing LIBOR and Looking Forward to Backward-Looking Rates: Completing the Generalized Forward Market Model. The later is sometimes referred to as FMM (Forward Market Model) and led to its inventors being awarded the Quant of the Year in 2020, so it definitely worth reading.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.