Reform of Interest Rate Benchmarks and Its Implikations on Derivatives Pricing: From IBORs to Risk-free Rates

Simone Rebbe

Student thesis: Master thesis


This master thesis deals with the transition from Interbank Offered Rates (IBORs) to the alternative, nearly risk-free rates (RFRs). IBORs are the most widely used reference rates for financials contract such as interest rate swaps, floating-rate bank loans, and mortgages and play a critical role in the global financial markets. Transitioning to the RFRs will be a demanding and complex process for the financial industry as RFRs are structurally and fundamentally different from IBORs.
IBORs are forward-looking term rates and are quoted for maturities up to 1 year. The rates are supposed to reflect the rate at which prime banks can borrow money on an unsecured basis. IBORs include a risk premium that reflects the credit and liquidity risk involved in lending in the interbank market. By contrast RFRs are overnight rates and are considered to be nearly risk free. Furthermore, RFRs rely entirely on transactions from liquid money markets, whereas IBORs are partially based on “expert judgments”. Given these differences, the RFRs need to be adjusted before they can be used as a replacement for IBORs in both new and existing contracts.
The main part of the thesis considers the Forward Market Model (FMM), which is an interest rate modeling framework for forward risk-free term rates. We describe the derivation of the modeling framework and show that by modeling the dynamics of the term rates directly, we can simulate both forward-looking and backward-looking term rates using a single stochastic process for both. Then we turn to the valuation of RFR vanilla derivatives and derive pricing formulas for fixed-for-float interest rate swaps and caps.
Finally, we examine how financial contracts referencing IBORs will be affected once the interest rate benchmarks discontinue. Most derivatives will use the fallback language developed by ISDA, where the forward-looking IBOR term rate is replaced with the backward-looking RFR term rate plus a fixed spread to account for the differences between the two. ISDA’s fallback rate is designed to reduce the likelihood and size of any value transfer between parties, but it cannot eliminate all the risk. We analyze the historical spread between 3-month LIBOR and 3-month SOFR, and show that the spread can be highly volatile, particularly in times of stressed markets. We find that the current fallback methodology exposes users to the possibility of a large arbitrary jump in the value of IBOR-indexed payoffs around the discontinuation date.

EducationsMSc in Business Administration and Management Science, (Graduate Programme) Final Thesis
Publication date2020
Number of pages86
SupervisorsSøren Bundgaard Brøgger