In July 2018, the International Swaps and Derivatives Association (ISDA) published an initial market-wide consultation requesting feedback on potential Benchmark Fallbacks methodologies covering GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW. In May this year, ISDA extended the consultation to include USD LIBOR, HIBOR and CDOR.
The objective of the fallback methodology is to construct a synthetic rate which approximates the existing IBOR, using the relevant overnight Alternative Reference Rate (ARR) and through the application of both a term and credit adjustment, so it can serve as a mechanism to transitioning existing Derivative contracts in the event of specified triggers.
In our latest research paper, we explore how effectively the proposed methodologies replicate the existing IBOR term structure as to minimise value transfer. To do this, we have backtested how well the proposed fallback methodologies empirically fit the historical IBOR time series by calculating the average root mean squared error (RMSE) of mean and volatility of each of the IBOR term rates using five years’ data.
Our comparisons conclude that the methodology preferred by most respondents to the initial consultation is not optimal and indeed could be more accurately modelled. We also suggest that alternative methodologies which make use of official forward looking ARR term structures should be considered where they are supported by the specific jurisdiction.
ISDA are expected to run an additional consultation on key parameters which can impact the adjustment spread later this year. The finalised methodology will impact real profit & loss (P&L) exchanged between counter-parties and is therefore key to commercial relationships and litigation risk.
We encourage firms to prioritise quantitative analysis of the various combinations of parameter options and fallback methodologies, and run P&L impact analysis on legacy positions to inform their consultation feedback and their own transition strategy.
Read the full paper
For more information contact:
Global Advisory Practice