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Guide

Impact on valuations from market participant adoption of SOFR discounting

Summary

In October 2020, in support of global reference rate reform efforts, both CME and LCH changed their approach to discounting certain cleared USD-denominated derivatives, including interest rate swaps. Previously, USD-denominated derivatives were discounted using the Fed Funds Overnight Index Swap Rate (OIS). After October 2022, the clearing houses changed the discount rate to the Secured Overnight Funding Rate (SOFR). We anticipated that market participants would subsequently migrate to valuing non-cleared USD interest rate swaps using SOFR discounting as well. We have continued to monitor the activities of market participants to determine whether a change from OIS to SOFR discounting is necessary beyond the centrally cleared trades referenced above.

Based on our interactions with and feedback from dealer banks, we believe that most market participants have transitioned to using SOFR for discounting. As a result, Chatham intends to make this transition for non-cleared derivatives (except for cross-currency swaps) in Q2 2022.

The remainder of this memo provides answers to key questions about the impact of the change to SOFR discounting on non-cleared transactions.

Q: What change in valuation methodology are we making?

A: Effective May 20, 2022, we will cease using OIS discount factors and replace them with SOFR discount factors for interest rate swaps and options (e.g., caps), commodity swaps and options, and foreign currency forwards and options.

Q: Why are we making this change?

A: We are making this change due to our observations that most market participants have already migrated to this approach for transaction pricing.

Q: Where is this change being made?

A: This change is being made with respect to fair value measurements on interest rate swaps and options, commodity swaps and options, and foreign currency forwards and options that we provide in periodic valuation reports as well as in accounting reports that we provide to our accounting clients.

Q: Can Chatham provide information to help companies assess whether the changes in valuation methodology are expected to result in material changes to the values of derivatives?

A: Yes, your Chatham representative can provide an estimated impact of the methodology change upon your request. 

In addition, we compared the valuation of impacted trades as of March 31, 2022 using OIS discount factors against SOFR discount factors. Our comparison included approximately 60,000 interest rate swaps and interest rate options, 20,000 commodity swaps and options, and approximately 100,000 foreign currency forwards and options. Below is a summary of valuation differences by product.

  • Interest rate swaps and options: 99% of the SOFR discounted values were within +/- 1 basis point of the OIS discounted value.

  • Foreign currency forwards and options: 99.9% of the SOFR discounted values were within +/- 0.5% of the OIS discounted value.

  • Commodity swaps and options: 95% of the SOFR discounted values were within +/-1 basis point of the OIS discounted value.
    • All differences outside this range were no more than 0.20% different from the clean price of the transaction determined using OIS discounting.

Q: When are we making this change?

A: Effective May 20, 2022

Q: How should this change be treated under U.S. GAAP?

A: ASC 820-10-35-25 indicates that valuation techniques used to measure fair value shall be consistently applied. However, a change in a valuation technique or its application (for example, a change in its weighting when multiple valuation techniques are used) is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. For example, this might be the case if any of the following events occur:

  1. New markets develop
  2. New information becomes available
  3. Information previously used is no longer available
  4. Valuation techniques improve
  5. Market conditions change

The change in valuation methodology is primarily the result of recent developments in market conditions rather than a change in accounting principle. Therefore, this change should be treated as a change in estimate in accordance with ASC 250-10-45-17, which indicates “A change in accounting estimate shall be accounted for in the period of change if the change affects that period only or in the period of change and future periods if the change affects both. A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods."

In addition, in accordance with the disclosure provisions of ASC 820, entities are required to include a description of the valuation technique (including any change in the valuation technique and the reason for making the change) and the inputs used in the fair value measurement. Accordingly, we recommend that each company, along with their auditor, assess the materiality of the impact and as warranted, include appropriate disclosure around this event. In those situations, Chatham will be happy to assist with any associated footnote disclosures.

Q: For derivatives designated in hedge accounting relationships under US GAAP, will the change require a designation of the original hedging relationship?

A: No, we do not believe that a change in estimate in the valuation of the derivative necessitates a dedesignation of the original hedging relationship. This conclusion is based on the premise that the critical aspects of the hedging relationship remain intact (i.e., identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and methods for assessing hedge effectiveness and measuring hedge ineffectiveness).

Q: How will the change impact the classification of the fair value of derivative instruments within the fair value hierarchy of ASC 820?

A: We anticipate that the change will not impact the classification of the fair value of derivative instruments within the fair value hierarchy of ASC 820. The new data will continue to be a level 2 input similar to the previously used data.

Q: Is SOFR considered a benchmark interest rate in accordance with ASC 815?

A: Currently, only the SOFR OIS swap rate is considered a benchmark interest rate. However, the FASB recently issued a proposed ASU in which the definition will be expanded to include the SOFR swap rate, including term SOFR, rather than only the SOFR OIS swap rate.

Q: Will it be appropriate to use SOFR discount factors to discount the cash flows of a hypothetical derivative in a cash flow hedging relationship in accordance with ASC 815?

A: Yes, the hypothetical derivative’s cash flows would also be discounted using the same SOFR discount factors as the actual derivative.

Q: What impact will the transition to SOFR have on retrospective and prospective hedge effectiveness assessments?

A: After the transition date to SOFR, all subsequent data points in the regressions will be based on SOFR discount factors. From a practical perspective, this means that for any regression data points in a hedging relationship that existed before the transition date will not be recalculated using SOFR discounting. All new data points added to the regression after the transition date will be calculated with SOFR discounting. This will result in a mixed set of regression data points (i.e., some data points will be discounted with OIS and some data points will be discounted with SOFR). We believe this is reasonable and appropriate for the following reasons:

  • We reperformed a sample of regression analyses in which we replaced OIS discount factors with SOFR discount factors. The results of our analysis indicated no significant change in the regression results and no change in the conclusion that the hedging relationship would continue to be highly effective.
  • The maximum impact on R2 was 0.001. The maximum impact on slope was 0.001.

We also performed a comparison of regression data points valued using OIS discounting and SOFR discounting, noting that the differences in values in all cases were no greater than 0.7% and had a negligible impact on regression statistics.

Q: What is the impact of the change in discounting on ASC Topic 848 elections?

A: ASC 848-30-25-7 indicates that a change to the interest rate used for margining, discounting, or contract price alignment for a derivative that is a hedging instrument in a fair value hedge, a cash flow hedge, or a net investment hedge shall not be considered a change to the critical terms of the hedging relationship that requires dedesignating the hedging relationship because of that change. As a result, we do not expect any impact to elections made under Topic 848. However, please contact your Chatham Accounting manager for specific information regarding the application of Topic 848 to your hedging program.

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