SOFR Futures and Options

CHAPTER 3SOFR Lending Markets and the Term Rate

As we saw in Chapter 2, the switch from the forward-looking LIBOR term rate to the backward-looking overnight SOFR is relatively easy to implement in the futures market. Both the Eurodollar (ED) futures contract and the SOFR futures contract refer to the same segment of the forward yield curve: ED futures via a forward-looking term rate, and SOFR futures via a backward-looking overnight rate. While the difference between the two has implications for the front-month contract, for back-month contracts the transition from LIBOR to SOFR is almost limited to an exercise in renaming the contract months.

In contrast to the easy implementation in the futures market, the transition to SOFR encounters more resistance in the cash loan market, which would require calculating the interest in arrears if implemented in the same manner as in the futures market. To understand the difficulties involved, consider the example of a borrower, such as a corporate treasurer, used to borrowing at LIBOR term rates. In theory, exactly the same method applied for futures also can be applied to cash loans. Rather than basing lending on forward-looking term rates such as LIBOR, it can be based on backward-looking overnight rates such as SOFR. But for the borrower in our example, this would mean that the rate is determined at the end of the reference period by the SOFR values observed during that period, rather than at the beginning of the loan by a forward-looking ...