Standard Chartered, helping corporates prepare for risk-free rates, describes the potential risk of “valuation jump.”
The replacement of Libor by risk-free rates (RFRs) like the secured overnight financing rate (SOFR) in the US and the sterling overnight indexed average (SONIA) in the UK has been a hot topic at NeuGroup fall meetings where banks, regulators and other experts have been helping members prepare for Libor’s planned demise at the end of 2021.
- At a second-half meeting of the Asia Treasurers’ Peer Group, sponsor Standard Chartered brought to light a topic that has received less attention than other issues: Corporates switching to SOFR for over-the-counter derivatives face the “potential risk of valuation jump”—meaning the size of their derivative books may change, creating mismatched hedges.
Basis risk. Standard Chartered’s presentation included two scenarios where valuation changes create the potential for basis risk—when a hedge is imperfect because the derivative does not move in correlation with the price of the underlying asset.
- Case 1: A corporate has GBP fixed-rate bonds and entered into multiple fixed to floating-rate interest rate swap contracts to convert the bonds from fixed to floating (GBP 3M Libor +spread).
- Case 2: An institution invested in a portfolio of GBP fixed-income instruments. In managing the interest rate risk, it entered into multiple fixed to floating-rate swap contracts to convert the return of the underlying bonds from fixed to floating (GBP 3M Libor +spread).
- Problem: “The Libor discontinuation presents a potential risk of valuation jump in both cases,” Standard Chartered states. “Depending on the final transition methodology and levels being agreed upon after the transition, the cash flows and valuation of the swaps are likely to be based on the prevailing SONIA swap curve.”
- Solution: “Corporates can consider a Libor/SONIA basis swap to hedge against the risk of valuation jump.”
Discount rates, PV math. A risk of hedging mismatches also arises from the use of a different discount rate, such as SOFR, to determine the present value (PV) of a derivative that a corporate is using to hedge an exposure.
- The change in the discount rate index can impact hedging if it is inconsistent between the underlying exposure and the hedge instrument.
- For an over-simplified example, consider a $100 million asset discounted at a 2% risk-free rate to a PV of $98 million. To hedge, the corporate could have a derivative on its books with an exact, matching notional value of $100 million. But if that amount is discounted at a different risk-free rate of 1%, the derivative would have a PV of $99 million, creating a hedging mismatch.
Be prepared. Standard Chartered’s recommendations to prepare for the end of Libor include reviews of systems, documentation, processes and pricing—where it says to develop pricing mechanisms based on RFRs.
- The bank says to consider changes to systems and processes, such as incorporating new interest rate curves, historical RFR data, RFR methodologies and market conventions, and new pricing and valuation methodologies.
- In October, Chatham Financial, which helps corporates manage hedging programs, switched to using SOFR discounting on valuations for cleared swaps that trade on exchanges. It says that if your portfolio includes cleared swaps, you may need to take action to switch the valuation methodology from OIS to SOFR discounting.
- Chatham expects that all uncleared USD transactions will move to be discounted on SOFR soon.
- The firm notes that many corporates are initially focusing on the operational impacts of ASC 848 elections and disclosures, determining whether ISDA Protocol adherence is appropriate, and ensuring they have access to accurate payment calculations, valuations and journal entries.