MARCH 5TH, 2021 – Are you ready for Risk Free Rate Floater Bond pricing changes?

As many of you know, LIBOR and the equivalent EU benchmarking rates are coming to the end of their lives as a result of the EU Benchmarking Regulation. That means that firms willing to issue floating-rate coupon bonds will soon be forced to reference coupon values against new Risk Free Rates. However this is not as simple as replacing one rate with another; new calculations are required.

Focus on the LIBOR replacement challenge

The main currencies affected by the LIBOR decommission are US Dollars and Pound Sterling, where the legacy benchmark will be replaced by the new SOFR and SONIA Risk Free Rates (RFR).

The key challenge is that the LIBOR rate which was previously used was a forward-looking rate – it was agreed at the start of an interest period but was based on opinion (which could be influenced – hence its demise) while  the new Risk Free Rates are backward-looking – they cannot be determined until the end of an agreed interest period – and, as a result, are calculated from fact.

Therefore the analytics behind calculating the coupon value and ultimately the price of RFR floaters are more complex. The interest accrues each day, at the RFR setting plus the pre-agreed premium. The next day would accrue based on the next RFR rate setting which is done overnight.

The fact that the Overnight Indexes are not fixed in advance is the main challenge when pricing these types of bonds. We face a completely new way to calculate both the Accrued Interest and the future coupons remaining on the bond.

Calculating from SONIA Rates

So when we want to price a floating bond referencing an RFR benchmark, we need to compound all the ‘historical’ rate values to calculate the correct Accrued Interest day by day. The starting point for this calculation is the definition of the “lag” for the bond we wish to price: the number of days to shift back in order to determine the rate value considering the current reference date. This means using a financial market calendar to calculate this lag correctly, and once we have this we can then work out the Accrued Interest accurately.

Another significant difference in pricing implementation is related to the new method for calculating the first coupon payment, i.e. the value of the cash flow at the next payment date. In the IBOR-reference floaters, this cash flow is strictly related to the coupon value discounted using a discount factor depending on the so-called Index To Next Coupon[1]. Instead, for RFR floaters, the cashflow at next coupon date is related to the historical values of the benchmark from the previous coupon date until the current reference date.

SoftSolutions have already implemented a solution in our nexRates pricing engine based on the approaches above by updating our pricing algorithms. This allows traders to seamlessly price the RFR floaters by the classic Discount Margin model they used to apply for the LIBOR-linked floaters.

Conversion from Discount Margin spread to the price, and the related inverted calculations, have been tested and proved to the recognized market standard up to the 6th decimal digit.

nexRates risk engine also provides accurate calculations of Macauley Duration, Modified Duration and Basis Point Value, allowing nexRates aggregated risk matrix to include RFR floaters along with the LIBOR-linked ones.

This challenge is not just limited to LIBOR. We’ve also seen firms start to issue papers linked to Risk Free Rates for EUR-denominated bonds too, using €STR instead of EURIBOR, despite the fact that EURIBOR likely to be around for the foreseeable future . The challenge is answered in the same way and the pricing methodology is incorporated into the nexRates platform.

About SoftSolutions

We are passionate about Fixed Income Electronic Trading; from quoting via Excel on EuroMTS in 1998 to no-code RFQ workflow customization to seamless EGB primary auctions, our sell-side and buy-side clients have been thriving in bond e-trading. The business is born from engineering. All our products are designed, built and developed in-house and we are fully committed to a roadmap of future innovation and development. Our SoftSolutions! Academy ensures that our highly skilled technology teams remain current and confident incorporating the very latest technology advancements and applying modern agile delivery methodologies.

Alice and Andrea relentlessly explore how we can expand our bond and derivative pricing capabilities including conversations with our clients and other peers in the quant community (thanks QuantLib friends!) to facilitate comprehensive bond pricing. If you want better options in pricing and trading bonds globally, drop me a line via LinkedIn or reach out at info@softsolutions.it.

The Index To Next Coupon is the value in the IBOR curve linearly interpolated at the number of days between current settlement date and next coupon date.