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Arbitrage-Free Pricing and Hedging of SOFR Swaps

Article arXiv papers · Author: Matthew Bickersteth et al.
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Summary

This document outlines a framework for pricing and hedging interest rate swaps linked to the Secured Overnight Financing Rate (SOFR), a U.S. dollar reference rate introduced as a successor candidate to LIBOR. It considers both swaps with collateral and swaps without collateral, recognizing that collateral arrangements affect valuation and hedge costs.

The proposed hedges use SOFR futures alongside funding rates specific to the hedge and margin accounts. A one-factor Vasicek model specifies the joint dynamics of SOFR and other overnight rates, including an unsecured funding rate, to support arbitrage-free valuation and hedge analysis. The description gives the model setup and instruments but reports no empirical results, calibration details, or assessment of hedging performance. Its use of a simplified one-factor model may also limit how well it captures the complexity of interest-rate and funding markets.

Key ideas

  • The framework prices SOFR-referenced swaps with and without collateral.
  • SOFR futures serve as hedging instruments alongside account-specific funding rates.
  • A one-factor Vasicek model describes the joint dynamics of relevant overnight rates.
  • The document describes a modeling approach but provides no empirical performance evidence.

Tags

Fixed incomeFuturesDerivatives pricingRisk management
Full text
# Pricing and hedging of SOFR derivatives


# Pricing and hedging of SOFR derivatives









The LIBOR has served since the 1970s as a fundamental measure for floating term rates across multiple currencies and maturities. However, in 2017 the Financial Conduct Authority announced the discontinuation of LIBOR from the end of 2021 and the New York Fed declared the Treasury repo financing rate, called the Secured Overnight Financing Rate (SOFR), as a candidate for a new reference rate for interest rate swaps denominated in U.S. dollars. We examine arbitrage-free pricing and hedging of swaps referencing SOFR without and with collateral backing. As hedging instruments, we take SOFR futures and idiosyncratic funding rates for the hedge and margin account. For simplicity, a one-factor model based on Vasicek's equation is used to specify the joint dynamics of several overnight interest rates, including the SOFR and unsecured funding rate.

Shown in full with attribution under the source's licence. Licence: abstract CC0

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