Pricing and risk models need to be adjusted to the Alternative Reference Rates (ARR). Entities will encounter several challenges in this process, the most critical being the lack of historical time series data, and absence of term structures and embedded credit risk components. The asymmetries between the benchmarks may ultimately lead to an increase of basis risk, as well as undesired transfer of value between parties and hedging mismatches. Author: Simon Woods
Need for credit spread
A substantial difference between Interbank Offered Rates (IBOR) and ARRs is that the former includes the credit risk associated with bank borrowing, while the latter is virtually risk-free. The absence of a credit premium could lead to an adverse impact on the market if not appropriately considered when converting legacy contracts. To minimize the financial impact of the transition on legacy trades, the credit spread must be added on top of ARR. An option could be the use of Credit Default Swap spreads as a proxy of the bank’s default risk; however, this solution carries transparency and liquidity disadvantages.
In July 2018, the International Swaps and Derivatives Association (ISDA) launched a market-wide consultation on credit spread and term-fixing adjustment methodologies in the event an IBOR is permanently discontinued, and released the results in a report in December 2018. An overwhelming majority of respondents preferred the “compounded setting in arrears rate” for the ARR and a significant majority preferred the “historical mean/median approach” for the spread adjustment. Most respondents preferred to use the same adjusted ARR and spread adjustment across all benchmarks covered by the consultation. ISDA will now proceed with developing fallbacks for inclusion in its standard definitions based on the results in the report.
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