With the imminent transition from LIBOR to SOFR next year, what are the data points practitioners are using to construct a yield curve? Also, since LIBOR implicitly took into account credit risk of the counterparty due to the fact that this is an interbank rate, how will derivatives transactions incorporate credit risk?
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2$\begingroup$ from practitioner point of view its next logical step after moving from single curve to dual curve. $\endgroup$– Gogo78Dec 18, 2019 at 15:07
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$\begingroup$ Currently for SOFR, there's liquidity in Futures so up to 6M. Beyond that, in some places it seems what is being used are SOFR-FF basis swaps (even though I believe liquidity is scarce) until there's enough liquidity in the float-fixed market. $\endgroup$– Daneel OlivawApr 7, 2020 at 15:50
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$\begingroup$ Also, note that it might be the case that we will revert to single-curve framework after the dust settles. For example, CME/LCH are moving to SOFR discounting, whereas SOFR is also going to become the main referenced rate for many derivatives. $\endgroup$– Daneel OlivawApr 7, 2020 at 15:51
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1 Answer
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Like any curve construction, you would use the prices of traded assets to construct the curves. For example, in the standard LIBOR, people use FRA, futures, and swaps referencing LIBOR to construct the LIBOR curve ( say 3 months or 6 months). For SOFR, you can use SOFR futures and swaps, so don’t think there is much difference, the problem at the moment is liquidity!
answered Dec 18, 2019 at 18:37
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1$\begingroup$ Yes, but which contracts provide enough liquidity? Are there enough traded products to span an entire term structure of about 30Yrs? What would you use as the crossover point between futures and swaps? Does current data provide for smooth interpolation and forwards? How would you adjust if there is a large basis between SOFR and Libor (how much is attributed to credit risk and how to liquidity/). Trying to understand what adjustments etc that practitioners are making to construct a usable curve for valuation. $\endgroup$– AlRacoonDec 18, 2019 at 19:04
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$\begingroup$ currently none I would say (chicken and egg kinda situation), but the volumes are growing, hoping there would be enough liquidity by the time the transition happens. $\endgroup$ Dec 18, 2019 at 20:44
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$\begingroup$ re-transition between futures and swaps, it will depend on the liquidity (sorry sounds circular!) and the trading mandate, but as modellers, the YC code would normally be flexible to accommodate all sort of relevant instruments and any crossover between instruments. One can also look to incorporate additional instruments as they emerge (some new ones are very likely to emerge). Re-basis, there has always been basis between different curves (take sonia as an example) so don't think the basis is going to be an issue. Hope this helps $\endgroup$ Dec 18, 2019 at 22:49
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$\begingroup$ Thanks very much for your comments and answer. I think this topic is going to be increasingly important as we approach the big bang date. I'm guessing liquidity in the SOFR based instruments should pick up as well. $\endgroup$– AlRacoonDec 18, 2019 at 23:02