For the investment world, 2021 is heading our way quickly. As we look forward, the pillars of new risk-free term rates (RFRs) are being raised and practical architecture is being built around them. As an industry practitioner and academic about rates and markets, Fabio Mercurio, global head of quantitative analytics at Bloomberg L.P. and adjunct professor at NYU, shared his thoughts on LIBOR replacement at a recent Bloomberg Quant Seminar. Mercurio has written extensively on topics in quantitative finance and risk, including his recent paper, co-authored with Andrei Lyashenko, “Looking Forward to Backward-Looking Rates: A Modeling Framework for Term Rates Replacing LIBOR” .
Interbank Offered Rates (IBORs) play a very significant role in the world of contracts and derivatives, serving as the reference rates in millions of financial contracts, with a total market exposure exceeding hundreds of trillions of dollars. Thus, effective and efficient solutions are essential for a migration to the post-LIBOR environment.
As regulators, industry organizations and market participants have been developing an alternative framework for new benchmarks, a number of solutions have emerged: the US is working with SOFR, the UK with a reformed SONIA, Switzerland has selected SARON, Japan TONAR, and the Eurozone has adopted the Euro Short-Term Rate, or €STR, which it plans to begin publishing in October 2019.
Seeking substitutes for IBORs
All of these RFRs are overnight rates and must be converted into term rates before they can serve as substitutes for IBORs in any kind of contract, new or old. In an effort to ensure a smoother transition, the ISDA and regulators are looking at two main approaches: 1) a compounded, backward-looking, setting-in-arrears rate, which is known at the end of the corresponding application period, and 2) a market-implied prediction of this rate, which is then forward-looking and known at the beginning of the application period.
In the current environment, the backward-looking rate was chosen as the RFR term rate in the definition of the LIBOR fallback for derivatives and is seen in new RFR futures and vanilla swaps, for example. The forward-looking rate seems to be preferred in defining fallbacks for cash instruments. But, one might ask, “Is there a way to unify these two worlds?” Mercurio and Lyashenko have developed a modeling framework where the backward-looking and forward-looking rates can be modeled jointly. Thus, it does not matter if some contracts will use the first rate and others use the second rate, because it is possible to have a framework that accommodates both, as they have shown.
Their work in this area focuses, in part, on defining and modeling forward risk-free term rates, based on the array of new interest-rate benchmarks that will be replacing IBORs globally. By modeling the dynamics of term rates directly, it is possible to simulate the forward-looking, IBOR-like rates and the backward-looking, setting-in-arrears rates using a single stochastic process for both varieties. This leads to what they call a generalized forward market model (FMM), which is an extension of the classic single-curve LIBOR Market Model (LMM), with the benefit that the FMM provides additional information about the rate dynamics between fixing/payment times.
The FMM formulation is based on the concept of extended zero-coupon bonds — useful when handling backward-looking setting-in-arrears rates. With such an approach, bonds, forwards, and swap rates, along with their associated forward measures, can all be defined at all times, even beyond their natural expiries.
As the market continues to develop alternatives to LIBOR, the FMM is a noteworthy development that offers several advantages over the classic LMM and can be further enhanced by adding LIBOR-like rates in a process described in one of Mercurio’s earlier papers (2010). In this way, a multi-curve model can be constructed through modeling RFR term rates jointly with forward LIBORs or LIBOR proxies. The FMM is not an alternative to LIBOR itself, but rather an extension of an old model, the LMM, which is compatible with the new RFR term rates chosen as LIBOR replacements. While the sun is setting on LIBOR, it will rise again with insightful market innovation.
Lightning talks
Following a short Q&A session, Bruno Dupire, the host of the event, kicked off a series of “lightning talks,” 5-minute presentations where industry experts, researchers and academics present a wide range of subjects to stimulate fresh thinking and interaction between various disciplines. Each talk examines a way that the industry is evolving and serves as an essential exploratory aspect of the Bloomberg Quant Seminar series.
In this session, Hongjing Zhang of the Stevens Institute of Technology discussed Santiment* analysis on natural gas: Vol. II (no, it is not a typo, it refers to an important literary inspiration for the work). David Mitchell of Bloomberg L.P. discussed factor decompositions, and Tony Zhou, a top-ranked horse betting tournament player discussed Benter, boosting and beyond.
Other lightning talks featured Mohsen Mazaheri of FF Capital Partners who offered thoughts on risk weights and portfolio construction, Arka Bandyopadhyay of Baruch College, who provided insights on deep learning for risk in commercial mortgages, and Achintya Gopal of Bloomberg L.P. on Quantum Machine Learning.
About the Bloomberg Quant seminar series
The Bloomberg Quant (BBQ) seminar series takes place in New York and covers a wide range of topics in quantitative finance. Each session is chaired by Bruno Dupire, head of Quantitative Research at Bloomberg LP, and features a keynote speaker presenting his or her current research. This presentation is followed by several “lightning talks” of five minutes each in quick succession. This format gives the audience the opportunity to be exposed to a wider variety of topics. Sign up to receive invitations to future events in this series.