As Libor’s time dwindles, many are growing concerned about the potential business impact its demise could create. In approximately three years’ time, Libor, the interest rate that underpins $350 trillion of financial contracts will meet its end. The coexisting challenges such as lack of alternative benchmark liquidity, contract novation for fallback terms, and related issues in overhauling existing technology are leading to a great deal of uncertainty around the transition to new benchmark rates.
The big questions for many right now are: “How can firms prepare for the transition from Libor to alternative benchmark rates?,” and “What is the best strategy to navigate this transition when many of the details are still uncertain?” To help answer these questions, below are four informative resources that offer insight.
Phasing Out Libor Brings Major Challenges to Risk Management
There is no denying that Libor’s discontinuation will come as a major upset to financial institutions and commercial investors alike, as historically Libor has played a significant role as a benchmark rate. Additionally, many financial models rely on Libor for fair-value pricing and risk management, so investors can expect to face serious challenges, such as issues with unsecured lending risk, as they transition Libor to alternative benchmarks. In this blog post, we discuss these challenges in more detail and provide insight on how firms can minimize the risk the Libor transition is bound to create. Read more.
Replacing Libor with Alternative Benchmarks: Gauging the Risks
A major area of concern with Libor’s end is the impact it will have on pricing models. We may see a veritable tsunami of problems when trying to remove Libor and Libor-linked trades as modeling inputs. Without Libor curves, we will have far fewer curves available to a market which has been multi-curve for a decade. However, modern investors cannot forget the embedded credit risk in term lending. This means it could eventually be necessary to use complex credit models, like CVA exposure modeling on a sector basis, in order to recover the equivalent multi-curve modeling that is currently standard practice. The Libor curve models in use today are popular, partly because it is easy to get approval and much faster to calculate than some kind of exotic CVA calculation based on simulation and credit volatility inputs. The jury is out for now, as it is currently uncertain if markets will continue to provide the term-lending rates that Libor provides today. Read more.
Risk.net Special Report: Beyond Libor
This special report, sponsored by FINCAD, offers the perspectives of several industry participants (including myself) on the impact of Libor discontinuation. In my portion, I consider that the end of Libor could throw payout calculations in current trades into chaos, triggering fallback definitions, which could ultimately lead to an immediate impact on valuation. Fallbacks only help counterparties agree on how to calculate payments, not how to value trades. The most natural method for pricing uses the Libor rate curves, but instead fallbacks must be valued consistently with the overnight rate derivatives market. Today, the derivatives markets used for interest rate forecasting are linked to Libor, and we will lose this valuable data for curve-building and pricing derivatives. The result could be many different prices for participants, with a potential impact on model risk. Read more.
Technical Paper: How The End of Libor Will Impact Delta-1 Rates
The initial step of preparing for the post-Libor world will involve the selection of alternative benchmarks. Each country or economic zone will have their own choice – in some cases using relatively new benchmarks, such as SOFR (USD) and ESTER (EUR), and in other cases using established overnight rates like SONIA (GBP). The first hurdle is an imminent need to grow the associated markets linked to the new rates. As a result, industry standards for modeling interest rates curves will need to quickly adapt to these major changes in benchmark rates and their reference markets. In this technical paper, I provide details on the immediate challenges and outlook for modeling in the end of Libor—spanning from the adaptation to future rates markets to the design of fallback language for legacy trades. Read more.
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