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P2.T9.908. What is the Secured Overnight Financing Rate (SOFR)?

Nicole Seaman

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Learning objectives: Explain the Secured Overnight Financing Rate (SOFR) and its underlying transaction pool. Compare the underlying interest rate exposures for SOFR futures and other short-term interest rate futures.


908.1. Easily the most popular reference rate for derivatives like interest rate swaps has been LIBOR, the London Interbank Offered Rate. According to John Hull, LIBOR is the reference rate "for hundreds of trillions of dollars of transactions throughout the world." However, the LIBOR scandal (https://en.wikipedia.org/wiki/Libor_scandal) greatly shook confidence and triggered a re-evaluation of this rate that is so integral to the global financial ecosystem. In June 2017, the Federal Reserve's Alternative Reference Rates Committee (ARRC) named the Secured Overnight Financing Rate (SOFR) as its preferred alternative to LIBOR. Each of the following statements is TRUE about SOFR EXCEPT which statement is not accurate?

a. The September SR3 contract is a three-month SOFR futures contract that starts on the third Wednesday of September and comes to final settlement on the third Wednesday of December
b. Both the one-month and three-month SOFR futures contract settle like Treasury bond futures: the short chooses the cheapest-to-deliver (CTD) among a basked of SOFR-bonds and a conversion factor is applied
c. The day's SOFR benchmark value is the transaction-weighted median repo rate; advantages of a median rate over an average include that it almost always produces an interest rate level that actually has been observed
d. SOFR's underlying transaction pool is massive and comprises a broad universe of overnight Treasury repo trade activity that includes BNYM tri-party GC Repo, FICC tri-party General Collateral Financing (GCF), and FICC DVP bilateral repo

908.2. In their paper (What is SOFR?), CME Group asked a natural question: how do the SOFR and the effective federal funds rate (EFFR) compare? With respect to this question, each of the following statements is true EXCEPT which is false?

a. The EFFR is secured, but SOFR is an unsecured rate
b. SOFR exhibits noticeably higher daily volatility than EFFR
c. On average, daily SOFR runs 3.9 basis points per annum lower than daily EFFR
d. Unlike EFFR, SOFR exhibits no systematic tendency to drop on the last business day of each month

908.3. Sally is a wicked-smart trader who believes that overnight interest rates are going to rise. Consequently, she enters a short position in a SINGLE three-month SOFR September 2018 futures contract. At that time, the September futures contract price is 98.720, which reflects a rate of 1.280%. In early December, as the contract's last trading day approaches, she settles the single contract when its price is 97.850. What is her gain/loss on the position (without regard to the time value of money)?

a. Loss of $87.00
b. Profit of $87.00
c. Profit of $2,175.00
d. Profit of $5,925.00

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