Interest Rate Contracts

A Contractual Interest Rate is the specific rate included within the terms of a note payable or bond payable. This rate is multiplied by the face amount of the note or bond to derive the amount of interest to be paid to the note or bond holder.

The Interest Swap

An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount.

The Construct of the Interest Rate Swap

Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.

A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap.

KEY TAKEAWAYS

  • Interest rate swaps are forward contracts where one stream of future interest payments is exchanged for another based on a specified principal amount
  • Interest rate swaps can be fixed or floating rate in order to reduce or increase exposure to fluctuations in interest rates

Interest Rate Swaps Explained

Because they trade over the counter (OTC), the contracts are between two or more parties according to their desired specifications and can be customized in many different ways. Swaps are often utilized if a company can borrow money easily at one type of interest rate but prefers a different type.

There are three different types of interest rate swaps: Fixed-to-floating, floating-to-fixed, and float-to-float.

Fixed to Floating

For example, consider a company named TSI that can issue a bond at a very attractive >fixed interest rate to its investors. The company's management feels that it can get a better cash flow from a floating rate. In this case, TSI  can enter into a swap with a counterparty bank in which the company receives a fixed rate and pays a floating rate. The swap is structured to match the maturity and cash flow of the fixed-rate bond and the two fixed-rate payment streams are netted. TSI and the bank choose the preferred floating-rate index, which is usually LIBOR for a one-, three- or six-month maturity. TSI then receives LIBOR plus or minus a spread that reflects both interest rate conditions in the market and its credit rating.

Floating to Fixed

A company that does not have access to a fixed-rate loan may borrow at a floating rate and enter into a swap to achieve a fixed rate. The floating-rate tenor, reset and payment dates on the loan are mirrored on the swap and netted. The fixed-rate leg of the swap becomes the company's borrowing rate.

Float to Float

Companies sometimes enter into a swap to change the type or tenor of the floating rate index that they pay; this is known as a basis swap. A company can swap from three-month LIBOR to six-month LIBOR, for example, either because the rate is more attractive or it matches other payment flows. A company can also switch to a different index, such as the federal funds rate, commercial paper or the Treasury bill rate.

Real World Example of an Interest Rate Swap

Suppose that PepsiCo needs to raise $75 million to acquire a competitor. In the U.S., they may be able to borrow the money with a 3.5% interest rate, but outside of the U.S., they may be able to borrow at just 3.2%. The catch is that they would need to issue the bond in a foreign currency, which is subject to fluctuation based on the home country's interest rates.

PepsiCo could enter into an interest rate swap for the duration of the bond. Under the terms of the agreement, PepsiCo would pay the counterpart a 3.2% interest rate over the life of the bond. The company would then swap $75 million for the agreed upon exchange rate when the bond matures and avoid any exposure to exchange-rate fluctuations.

Secured Overnight Financing Rate (SOFR); Chicago Mercantile Exchange (CME) Futures Contracts

The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight; collateralized by Treasury securities.

CME SOFR futures are the leading source of SOFR price discovery, trading alongside deeply liquid Eurodollar, Fed Fund and Treasury futures to offer seamless spread trading and unmatched capital efficiencies through margin offsets.

SOFR Futures Trade Data

The SOFR product strip consists of contracts with varying granularity and expiry dates, but with the same underlying, so volume and open interest should be considered in aggregate for SR1 and SR3.

SR3

Three-Month SOFR Futures

CME

Stirs

22,184

65,478

SR1

One-Month SOFR Futures

CME

Stirs

2,179

53,875

Trade Date: 06 May 2019 | FINAL

SOFR Futures Contract Specifications

Based on extensive customer input, CME Group launched 3-Month and 1-Month SOFR futures contracts. The 1-Month SOFR strip futures proves useful to participants who seek finer granularity in framing market expectations of future SOFR values over the nearby 1-month to 7-month interval during which the front 3-Month contract becomes more set each day from daily SOFR fixings.

Download full contract specifications

What is SOFR?

  • Endorsed by the Fed-sponsored Alternative Reference Rates Committee (ARRC) to be used in the USD marketplace
  • Published by the Federal Reserve Bank of New York in cooperation with the U.S. Office of Financial Research since April 3, 2018
  • Financially distinct but highly correlated with existing money market rates such as LIBOR and Effective Federal Funds Rate (EFFR)
  • Underpinned by the U.S. Treasury overnight repurchase (repo) market, for which the pool of eligible transactions is ~$750 billion per day
  • Calculated as a transaction-volume-weighted median repo rate
  • Data sourced from tri-party repo data from Bank of New York Mellon (BNYM), and cleared bilateral and GCF Repo data from the Depository Trust & Clearing Corporation (DTCC)

 

Why Trade CME SOFR Futures?

  • Futures are a reliable indicator of market expectations of SOFR along the curve
  • Leading source of liquidity, with 1 basis point wide markets out 18 months
  • Easy spread trading against Eurodollar and Fed Fund futures via CME Globex intercommodity spreads
  • Margin savings of up to 80% vs Eurodollars, 75% vs. Treasuries, and 65% vs Fed Funds
  • Robust network of block market makers
  • Trade alongside SOFR Swaps to offer the only holistic solution for trading SOFR

SOFR Issuance

22 institutions have issued a total of $98 billion notional in floating rate instruments tied to SOFR, with $62 billion issued in 2019 through May 1

SOFR Historical Fixings and Basis Spread Analytics

 

 

Understanding SOFR Futures

This note spells out the workings of CME Three-Month SOFR futures and One-Month

SOFR futures, examines how they complement the exchange’s established short-term

interest rate futures, and discusses inter-market spread trading.

Secured Overnight Financing Rate (SOFR)

The Federal Reserve System convened the Alternative Reference Rates Committee (“ARRC”) in November 2014 (i) to identify alternative reference interest rate benchmarks that are firmly based on transactions from a robust underlying market and that comport with the International Organization of Securities Commissions (“IOSCO”) Principles for Financial Benchmarks, and (ii) to formulate a plan to facilitate acceptance and use of the chosen alternative.

On 22 June 2017, the ARRC endorsed the Secured Overnight Financing Rate (“SOFR”) as its preferred alternative reference rate. Regular production and publication of SOFR began Tuesday, 3 April 2018.

The SOFR value for any US government securities market business day (“business day”) is published by the Federal Reserve Bank of New York (“FRBNY”) around 8:00 a.m. New York time on the next business day.2 SOFR comprises a broad enough universe of overnight Treasury repo trade activity to make it a benchmark for all seasons, firmly rooted in transaction data from multiple and diverse sources3 –

  • Tri-party Treasury general collateral (“GC”) repo transactions cleared and settled by Bank of New York Mellon (“BNYM”), excluding repo transactions made through the Fixed Income Clearing Corporation (“FICC”) General Collateral Financing (“GCF”) repo market, and excluding transactions in which the Federal Reserve is a counterparty.
  • Tri-party Treasury GC repo transactions made through the FICC GCF repo market, for which FICC acts as central counterparty.
  • Bilateral Treasury repo transactions cleared through the FICC Delivery-versus-Payment (“DVP”) service.

FRBNY applies various filters, trims, and inclusion rules to these data sources to isolate overnight Treasury GC repo transactions from other repo market activity, and to ensure that SOFR adheres to the IOSCO Principles.4 FRBNY then pools them, ranks the aggregate of repo trading volumes by their transaction rates, from lowest to highest, and computes the transaction-weighted median repo rate (ie, the repo rate for which half of the day’s trading volume is transacted at rates that are equal to it or less than it, and for which the other half of the day’s trading volume is made at rates that are equal to it or greater than it).

The transaction-weighted median repo rate becomes the day’s SOFR benchmark value.

The trade-volume-weighted median methodology brings at least three advantages. It is a more robust statistic than alternatives such as, e.g., the trade-volume-weighted average. The value it produces, moreover, is almost always an interest rate level that actually has been observed, at which business actually has been conducted. And it aligns with the calculation method for the daily effective federal funds rate (EFFR) and for the daily overnight bank funding rate (OBFR), which was adopted by the Federal Reserve in March 2016.

SOFR’s underlying transaction pool is massive. In 2017 average daily trading volumes ran $332 bln in BNYM tri-party Treasury GC repo, $21 bln in FICC GCF Treasury repo, and $393 bln in FICC DVP bilateral Treasury repo, making total average traffic flow of $745 bln per day (Exhibit 1).

Although the available 3-1/2 years of evidence is limited, the data suggest that SOFR and EFFR share a common trend (Exhibit 2). Their short-term dynamics are quite different, however, with SOFR exhibiting noticeably more volatility. Between September 2014 and April 2018, the median absolute value of daily change in SOFR was one basis point. For EFFR it was zero. In other words, half the time, SOFR rises or falls from its previous daily level by a distance of one basis point or more, while, at least half the time, EFFR doesn’t change from day to day.

Exhibit 1 -- Trade Activity ($ Billions per Day) in SOFR Data Sources, 22 Aug 2014 through 3 May 2018

 

Exhibit 2 -- Daily EFFR and Estimated SOFR Values (Basis Points per Annum), 22 Aug 2014 through 3 May 2018

CME Three-Month SOFR Futures<

CME Three-Month SOFR Futures Contract Specifications

Trading Unit

Compounded daily SOFR interest during contract Reference Quarter, such that each basis point per annum of interest = $25 per contract.



Reference Quarter: For a given contract, interval from (and including) 3rd Wed of 3rd month preceding Delivery Month, to (and not including) 3rd Wed of Delivery Month.

Price Basis

Contract-grade IMM Index: 100 minus R.

R = compounded daily SOFR interest during contract Reference Quarter.

Example: Contract price of 97.2950 IMM Index points signifies R = 2.705 percent per annum.

Contract Size

$25 per basis point per annum (or $2,500 per contract-grade IMM Index point)

Minimum Price Increment (MPI)

Contracts with Four Months or Less Until Termination of Trading:

0.0025 IMM Index points (¼ basis point per annum) equal to $6.25 per contract

All Other Contracts: 0.005 IMM Index points (½ basis point per annum) equal to $12.50 per contract

Termination of Trading

Last Day of Trading: Exchange Business Day first preceding 3rd Wed of Delivery Month.

Termination of Trading: Close of CME Globex trading on Last Day of Trading.

Delivery

By cash settlement, by reference to Final Settlement Price, on 3rd Wed of Delivery Month (or, more generally, first US government securities market business day following Last Day of Trading).

Final Settlement Price: Contract-grade IMM Index (100 minus R) evaluated on the basis of realized SOFR values during contract Reference Quarter:

R  =  [ Πi {1+(di /360)*(ri /100)} – 1 ] x (360/D) x 100

n  =  Number of US government securities market business days in the Reference Quarter

i  ~  Running variable indexing US government securities market business days during Reference Quarter

Πi=1…n  denotes the product of values indexed by the running variable, i = 1,2,…,n.

ri  =  SOFR value for ith US government securities market business day

di  =  Number of calendar days to which ri applies

D  =  Σdi (ie, number of calendar days in Reference Quarter)

Delivery Months

Nearest 20 March Quarterly months (Mar, Jun, Sep, Dec).



For each contract, Contract Month is the month in which the Reference Quarter begins.



Example: For a “Sep” contract, Reference Quarter starts on IMM Wed of Sep and ends with Termination of Trading on first US government securities market business day before IMM Wed of Dec, the contract Delivery Month.

Trading Venues and Hours

CME Globex and CME ClearPort: 5pm to 4pm, Sun-Fri.

CME Globex Algorithm

Allocation (A Algorithm, with Top Order Allocation = 100% and Pro Rata Allocation = 100%)

Block Trade Minimum Size

Asian Trading Hours (4pm–12am, Mon-Fri on regular business days and at all weekend times)

250 contracts

European Trading Hours (12am– 7am, Mon-Fri on regular business days)

500 contracts

Regular Trading Hours (7am–4pm, Mon-Fri on regular business days) page 3 on pdf

1,000 contracts

Product Codes

CME: SR3

Bloomberg: SFR Cmdty <GO>

In certain important ways – contract sizing and critical dates, for instance – the contract features resemble CME’s flagship Three-Month Eurodollar (“ED”) futures.

Contract Critical Dates

The “contract month” convention for naming SFR futures mirrors the established convention for ED futures.  To see how, consider two contracts:

  • One is a September 2018 SFR future that comes to final settlement on the third Wednesday of December 2018.  The interval of interest rate exposure that informs the contract final settlement price – the contract Reference Quarter -- starts on the third Wednesday of September 2018 and ends on the third Wednesday of December 2018.
  • The other is a September 2018 ED future that comes to final settlement on the Monday before the third Wednesday of September 2018.  The final settlement price is based on the USD three-month ICE LIBOR® corresponding to a three-month term unsecured bank funding transaction that settles on the third Wednesday of September 2018 and that matures three months later, in mid-December.  

Both are referenced as “September” contracts, and the interval of interest rate exposure for one is essentially the same as for the other.  Crucially, the settlement date for the ED contract’s hypothetical three-month term bank funding rate – the third Wednesday of September 2018 – is identical to the start date of the SFR contract’s Reference Quarter, the period over which daily SOFR interest is compounded.

Last Trading Day is the first business day before the 3rd Wednesday of the contract delivery month, ie, the business day first preceding the last day of the contract Reference Quarter.  

Example:  For the September 2018 SFR contract, the scheduled last day of trading is

Tuesday, 18 December 2018, as depicted above

 

Final Settlement Price is 100 contract price points minus daily compounded SOFR interest during the contract Reference Quarter, rounded to the nearest 1/100th of one basis point per annum. 

Example:  Consider a hypothetical June 2017 SFR contract. The contract Reference Quarter spans 91 days, from (and including) Wednesday, 21 June (the third Wednesday of June), until (and not including) Wednesday, 20 September (the third Wednesday of September).  Exhibit 4 details determination of the contract final settlement price on Wednesday, 20 September, when FRBNY would have published the SOFR value for Tuesday, 19 September.

On each Date:

“Days” = 

# days from SOFR trade/settlement day to next business day

“Gross Return” = 

1 plus (Days/360) x (SOFR/10000)

Example:

“Gross Return” on Fri, 1 Sep = 1 plus (4/360) x (110/10000) = 1.000122222

 

Final Settlement Rate:

[(Product of All Gross Returns) minus 1 ] x (360/91) x 100

Example:

[1.002670427 minus 1 ]

x (360/91) x 100   =

1.056432494 pct/yr

Round to the nearest 1/100th bp:

1.0564

Final Settlement Price:

98.9436   =   100 minus 1.0564

The computational conventions for compounding of daily SOFR values closely resemble those that apply in standard US dollar overnight index swaps (“OIS”), in which each OIS contract’s floating rate leg is based on business-day-compounded EFFR.  That is, SOFR will accrue as simple interest over weekends and US government securities market holidays and as compound interest otherwise.7

CME One-Month SOFR Futures

The structure of the One-Month SOFR (“SER”) futures contract resembles the exchange’s 30-Day Federal Funds (“FF”) futures in nearly all respects. Normally, the exchange will compute an expiring contract’s final settlement price on the morning of the first business day following the end of the expiring contract’s delivery month.  

Example:  For October 2018 SER futures, the delivery month ends on (and includes) Wednesday, 31 October, and determination of the final settlement price is scheduled to occur on Thursday, 1 November, after FRBNY has published the SOFR value based on trade activity for Wednesday, 31 October.

Like FF futures, the SER futures contract price is quoted in IMM Index form, equal to 100 price points minus the expected value of average daily SOFR interest during the contract delivery month.

Example:  If market participants generally expect the average level of daily SOFR to be 2.718 percent during the month of October, then the price of October SER futures should trade in the neighborhood of 97.280 or 97.285 (ie, around 97.282, equal to 100.000 minus 2.718).  If the October SER futures contract is eligible to trade in ¼ bp minimum price increments, then the price more likely would trade at or around 97.2800 or 97.2825 (as before, either side of 97.282).

1 Basis Point = $41.67

Gains or losses on a contract position are calculated simply by determining the number

of bps by which the contract price has moved, then multiplying by the value of one bp.  As with FF futures, each bp of contract interest is worth $41.67.  Thus, contract size =.

Price Increments = Either ¼ Bp or ½ Bp

The SER contract price trades in increments of either ¼ bp or ½ bp,

Examples:  For October 2018 SER futures, the first day of the Delivery Month is Monday, 1 October. Thus, the minimum price increment is ½ bp until the start of CME Globex trading on Sunday, 30 September (ie, for trade date Monday, 1 October).  From then until termination of trading in the contract, the minimum price increment is ¼ bp.

At any given time, the Exchange lists seven contracts for trading, one for each of the seven nearest calendar months.  By implication, a newly-listed SER futures contract trades for seven months until it goes to final settlement.

Complementarily Between SER and SFR

Prior to the start of the contract’s Reference Quarter, the SFR futures contract rate – the “Rate” portion of the “100 minus Rate” contract price – gauges market expectation of business-day-compounded SOFR during the Reference Quarter, expressed as an interest rate per annum.  After the nearby contract enters its Reference Quarter, the contract rate becomes a mix of (i) known SOFR values, ie, published values for all days from start of the Reference Quarter to the present, and (ii) market expectations of SOFR values for all remaining days in the Reference Quarter that lie ahead.

As the expiring contract progresses through its Reference Quarter, the forward-looking expectational component of its price plays a diminishing role in fair valuation.  In general, progressively decreasing uncertainty about the contract’s final settlement price means steadily less contract price volatility.

Market practitioners familiar with 30-Day Federal Funds futures will recognize this quandary immediately.  As an expiring FF contract makes its way through its delivery month, contract users know increasingly more of the daily EFFR values that will determine the contract’s final settlement price.  Room for price volatility in the contract shrinks accordingly.

Seen in this lightthe SER futures strip makes a useful complement to SFR futures for market participants who seek finer granularity in framing expectations of SOFR values, or who seek finer resolution of SOFR volatility, within horizons out to six months or so.

Spread Trading with SOFR Futures

For SFR futures, CME Globex enables trading of standardized intra-market calendar spreads and combinations, largely matching those available for ED futures.  Likewise for SER futures, CME Globex intra-market calendar spreads are enabled so as to match those for FF futures.

A diverse array of CME Globex inter-market spreads are available among SFR and SER futures and the incumbent ED and FF futures.  These are summarized graphically below and are discussed at greater length in the following paragraphs.

* For convenience of reference, GE is the CME Globex symbol for ED, ZQ is the CME Globex symbol for FF, SR1 is the CME Globex symbol for SER, and SR3 is the CME Globex symbol for SFR.

** Implied pricing is disabled when the minimum price increments in the nearby futures contract and in the spread are reduced from 0.5 basis points to 0.25 basis points.

 

Inter-commodity Spread Basics

All CME Globex inter-market spreads described here are subject to pro rata trade matching.  (For more information, see Appendix -- Technical Details of SOFR Inter-Commodity Spreads on CME Globex.)

The SER:FF spread comprises purchase (sale) of one One-Month SOFR futures contract and sale (purchase) of one 30-Day Federal Funds futures contract.  Each leg is weighted at $41.67 per bp in the corresponding underlying interest rate.

Similarly, the SFR:ED spread consists of the purchase (sale) of one Three-Month SOFR future and the sale (purchase) of one Three-Month Eurodollar future, with each leg weighted at $25 per bp in the respective underlying interest rate.

For instance, the SER:SFR spread comprises purchase (sale) of six SER futures (six contracts x $41.67 per bp per contract) and sale (purchase) of 10 SFR futures (10 contracts x $25 per bp per contract).

For each of the three spreads involving futures with different basis point values, the corresponding CME Globex inter-market spread is standardized so that each leg is weighted at $250 per basis point. 

Additionally, the one-month contract leg (either FF futures or SER futures) is split between two different futures delivery months so as to approximate coverage of the period of interest rate exposure embodied in the three-month contract leg.

The same construction and proportions apply to the CME Globex standardized FF:SFR spread and FF:ED spread (the latter of which was introduced in March 2018).

Hedging Repo Exposure in the Treasury Basis with One-Month SOFR Futures

A Treasury repurchase agreement (“repo”) is a key element of any Treasury cash/futures basis trade.

For example, being long a Treasury cash/futures basis position involves a long position in cheapest to deliver (or another note/bond eligible for funds borrowed in the Treasury repo market. For this purpose, the borrowing typically occurs in the overnight bilateral repo market with the bond or note posted as collateral for the loan delivery). Treasury note/bond and a DV01 weighted short position in the futures contract. The long basis typically involves financing ownership of a Treasury note or bond in the case of a long Treasury basis position; you would pay Treasury repo interest for as long as you hold. the basis spread.  Conversely, in the case of a short Treasury basis position, you receive Treasury reverse repo interest for as long as you maintain the position.

In either case, unexpected shifts in repo rates can significantly impact its profitability.

Bilateral Treasury overnight repo data are a primary input to the Secured Overnight Financing Rate (“SOFR”) benchmark, accounting historically for around 55 percent of the trade activity on which the benchmark is based. For this reason, the SOFR benchmark provides a reasonable proxy for your Treasury overnight repo exposure, and CME One-Month SOFR futures offer a good tool for managing this risk.

Suppose that on Sep 28, 2018, you initiate a long cash/futures basis spread in “Classic” 10-Year Treasury Note (“ZN”) futures for Dec 2018 delivery (“ZNZ18”). 

First, you identified the 2-7/8s of July 2025 to be the Treasury note that is cheapest-to-deliver for the ZNZ18 futures.  Assume you purchased $500 million face value of this note for a full price (price + accrued coupon interest) of $498,125,025.  On Oct 1, this purchase settles.  You intend to finance it by borrowing funds in repo until Dec 30, the day preceding the ZNZ18 contract’s last delivery day, Dec 31.

As a result, you expect to pay Treasury overnight repo from Oct 1 through Dec 30.   If you paid SOFR overnight for this time period, you would have paid an annualized rate of 2.241%, which represents the average daily SOFR for this 91 day period.  For your $500 M Treasury cash position, the cost from repo to finance your cash position would have been $2,821,754, if your overnight repo rate is identical to SOFR.

To hedge this overnight repo exposure, you would’ve sold similar amounts of October, November and December One-Month SOFR futures.

Based upon the timing of your basis trade, your positions result in exposure to the repo rate for 91 days, from Oct 1 through Dec 30

Given the timing of the trade and size of the cash position, you need to sell 302 One-Month SOFR futures distributed across three contract months by number of days to hedge your overnight repo exposure: Oct 102, Nov 100, Dec 100. (302 contracts = ($ full price of note*0.0001*91/360)/$41.67 SR1 DV01)

Assume that you sold each of the Oct, Nov and Dec 2018 One-Month SOFR contracts at their settlement prices on Oct 1. You held the Oct and Nov 2018 One -Month SOFR contracts until their respective final settlement prices. You covered the short Dec 2018 position at the settlement price on Dec 31, the first available trading day following the conclusion of your repo exposure.

Because of your futures hedges, you have locked in an average interest rate of 2.246%, nearly identical to the projected rate of 2.241% to finance your position. The average interest rate implied by the final settlement prices of the Oct, Nov and Dec contracts was 2.249%. 

The net profit/loss of the hedged positions was small relative to the cost of financing because repo rates were relatively steady.  Nevertheless, Treasury repo rates can change unexpectedly due to changes in factors that influence them such as monetary policy and bill issuance.  Repo hedgers are encouraged to be mindful of these risks when establishing a hedging strategy.

For example, consider the potential scenario of a surprise tightening of monetary policy.  Suppose the Federal Open Market Committee (FOMC) provided an inter-meeting rate hike on Nov 16 by increasing the target range for the effective federal funds rate (EFFR) from 2.25/2.50 to 2.50/2.75. 

Given the stable spreads between EFFR and SOFR, it is reasonable to assume daily SOFR would be 25 basis points higher for the rest of the applicable dates, Nov 16-Dec 30.  In this case, the daily SOFR for Oct 1-Dec 30 is projected to be 2.365%, 12.4 basis points higher than the observed annualized rate for this period.  As a result, your expected cost of financing is $2,977,888, an increase of more than $156,000. 

Your futures hedges would have produced a net gain of more than $164,000, which would fully compensate the higher cost of financing due to the rate hike. 

The implied repo rate for a Treasury bond or note future is defined as the rate of return to buying the note or bond and fulfilling futures delivery with it.

The bond or note with the highest implied repo rate is typically the cheapest-to-deliver. The implied repo rates are generally consistent with other short-term interest rates.  The note in our basis example, the 2-7/8s of July 2025, had the highest implied repo rate, and it was cheapest-to-deliver. 

Trading U.S. Money Market Spreads with SOFR, Federal Funds, LIBOR and Eurodollar Futures
SOFR Futures Launch

With CME’s introduction of One-Month SOFR (SR1) and Three-Month SOFR (SR3) futures in May 2018, market participants have gained an additional set of tools for risk management of short-term interest rate exposures. With open interest over 120,000 contracts and daily trading volumes exceeding 50,000 on some days, the SOFR futures liquidity pool has developed to support expanding spread markets against other short-term interest rate (STIR) futures products.

It helps that SOFR futures were designed to complement existing STIR contracts.  The SR1 contract mirrors the 30-Day Federal Funds (ZQ) futures, with the same settlement date, a tick value of $41.67 per 0.01 price points, and simple average calculation for final settlements.  Thus, for instance, a March SR1 pairs naturally with a March ZQ.

The SR3 contract parallels the Three-Month Eurodollar (GE) futures, referencing IMM dates as well as a tick value of $25 per 0.01 price points. 

With margin offsets of up to 85%, Globex inter-commodity spreads (ICS) between these contracts allow for efficient execution as well as capital-efficient hedging of relative movements among the underlying benchmark interest rates. 

Increasing activity in these spreads offers an effective and liquid tool for managing risk exposures arising from money market trends and monetary policy shifts.

New Drivers of the LIBOR-OIS Spread

As a general measure of money market risk and liquidity, the spread between LIBOR and EFFR-reference overnight index swaps (OIS) historically resides under 20 basis points during times of economic stability.  Increases in the spread are often driven by the credit component of LIBOR, as bank financing comes to be viewed as relatively risky. 

Both the banking crisis of 2008 and the European sovereign debt crisis of 2010 occasioned classic LIBOR-OIS increases, with spikes in the spread mirroring increased uncertainty about creditworthiness among institutional or sovereign borrowers.

Early 2018 saw a less dramatic liquidity-driven run-up, but with no associated credit crunch.  The large increase in Treasury bill issuance during Q1 – over $300 billion worth – attracted funds from other instruments. Thus, rates on Treasury-collateral overnight repurchase agreements (repo) rose, and both EFFR and US dollar ICE LIBOR® followed.

Among the implications is that the LIBOR-OIS spread can turn volatile, not only in response to bank credit swings but also during times when banks hold more than adequate reserves.  For market participants with exposure to movements between these rates, the inter-commodity spread can serve the same purpose as a basis swap.

Between late 2017 and spring 2018, the LIBOR-OIS spread increased from around 10 basis points to over 50.  When Treasury bill issuance subsequently dropped off, the spread retraced    

Exhibit: Fed Funds vs. One-Month SOFR futures spread (recent)

A glance at underlying STIR benchmark trends confirms the earlier observation about the smoothing effect of contract final settlement price mechanisms.  Short term swings in SOFR due to repo market volatility are dampened in their impact upon futures final settlement prices.  Futures market movements therefore incorporate underlying daily fixings but moderate any single daily rate change.

Spreads have seen increased activity in recent months, with average daily volume trending upward.  Bid-offer spreads of one basis point are typical, with market depth frequently sufficient to accommodate trade sizes running to several hundred contracts.

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