Impact on valuations from market participant adoption of SOFR discounting
In October 2020, in support of global reference rate reform efforts, both CME and LCH changed their approach to discounting certain cleared USD derivatives, including interest rate swaps. Previously, trades were discounted using OIS, but the clearing house change results in trades being discounted at SOFR. We anticipated that market participants would subsequently migrate to valuing non-cleared USD interest rate swaps at SOFR as well for practicality reasons and due to there being an immaterial difference. We have continued to monitor the activities of market participants since then to determine if a change from OIS to SOFR discounting is necessary beyond the centrally cleared trades referenced above.
Based on our interaction 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 first valuation report and other deliverables impacted by this change will be the May 31, 2022 reports.
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 23, 2022, we will discontinue using OIS discount factors and replace them with SOFR discount factors for interest rate swaps and options, 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 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 to our clients in periodic valuation reports and 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.
For additional information, we compared the valuation of impacted trades as of March 31, 2022 using OIS discount factors against SOFR discount factors. We found that for interest rate swaps and options, 99% of the SOFR discounted values were within +/- 1 basis point of the OIS discounted value. For foreign currency forwards and options, 99.9% of the SOFR discounted values were within +/- 0.5% of the OIS discounted value.
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