Pricing and hedging of SOFR derivatives

TL;DR

This paper explores the arbitrage-free pricing and hedging of SOFR interest rate swaps using a Vasicek-based model, considering collateral and various hedging instruments, to facilitate the transition from LIBOR.

Contribution

It introduces a one-factor Vasicek model for joint dynamics of overnight rates, enabling effective pricing and hedging of SOFR derivatives in a post-LIBOR environment.

Findings

Effective hedging strategies using SOFR futures and funding rates.

Model captures joint dynamics of overnight interest rates.

Framework supports transition from LIBOR to SOFR.

Abstract

The LIBOR has served since the 1970s as a fundamental measure for floating term rates across multiple currencies and maturities. However, in 2017 the Financial Conduct Authority announced the discontinuation of LIBOR from the end of 2021 and the New York Fed declared the Treasury repo financing rate, called the Secured Overnight Financing Rate (SOFR), as a candidate for a new reference rate for interest rate swaps denominated in U.S. dollars. We examine arbitrage-free pricing and hedging of swaps referencing SOFR without and with collateral backing. As hedging instruments, we take SOFR futures and idiosyncratic funding rates for the hedge and margin account. For simplicity, a one-factor model based on Vasicek's equation is used to specify the joint dynamics of several overnight interest rates, including the SOFR and unsecured funding rate.