What Is the🍃 Secured Over𒅌night Financing Rate (SOFR)?

The secured overnight financing rate (SOFR) is a rate that reflects the cost of borrowing overnight, backed by U.S. Treasury securities in the repo market. The rate 🅷is based on actual transactions, making it a risk-free, secured rate indicative of market conditions.

However, its overnight nature and lack of a built-in credit risk initially posed challenges for adoption, which have been addressed through SOFR averages and the term SOFR developed by the CME Group.

History of the SOFR

For some time, the 澳洲幸运5官方开奖结🍨果体彩网:Londo🃏n Interbank Offered Rate (LIBOR) served as the benchmark for global interest rates. However, because of its reliance on bank estimates rather than real transactions, as well as scandals in the early 2010s, regulators sought to have it replaced. Then SOFR was created.

How SOFR Works

This benchmark rate is published daily by the Federal Reserve Bank of New York and calculated using a volume weighted median approach, ensuring that higher volume transactions have a greater influence on the rate. For a rate with term structures, SOFR averages and term SOFR can be used for reference rates for loans, bonds, and derivatives.

SOFR vs. LIBOR

The main differences between SOFR and LIBOR are as follows:

• Collateralization: SOFR is backed by U.S. Treasurys while LIBOR is unsecured.
• Risk profile: SOFR is considered risk-free, but LIBOR includes credit risk because it reflects unsecured borrowing among banks, which can fluctuate based on economic conditions.
• Calculation methodology: SOFR is derived from actual overnight repos. Meanwhile, LIBOR was based on bank-submitted estimates, which made it more subjective and prone to manipulation.
• Maturities and term structure: SOFR was initially an overnight rate but was later expanded to include term SOFR to provide forward-looking rates like LIBOR.
• Transparency and manipulation risk: SOFR is transparent and transaction-based, making it difficult to manipulate because it relies on actual repo transactions. However, LIBOR was vulnerable to manipulation since banks could adjust their rate submissions to influence financial products linked to it.
• Market liquidity: SOFR operates in a large and highly liquid market, with trillions of dollars in daily transactions, ensuring stability. Meanwhile, LIBOR relied on declining 澳洲幸运5官方开奖结果体彩网:interbank volumes, making it less representative of true borrowing costs.
• Dominance and usage: SOFR has become one of the primary USD benchmarks for loans, bonds, and derivatives, replacing LIBOR, which was officially phased out in June 2023.

Example of SOFR

Suppose there is a company, XYZ, which is a U.S. based multinational. The company is taking out a $100 million floating-rate loan to fund its expansion efforts. The bank loan will have an interest𝄹 rate that rests periodically based on SOFR.

The structure of the loan might be as follows:

• Amount: $100 million
• Term: 5 years
• Rate: 3-month term SOFR + 2%
• Frequency: Quarterly

Over the y𒊎ear, the i♛nterest rate payments are as follows:

XYZ's chief financial officer (CFO) realizes that interest rates are increasing and sets up a hedge. XYZ enters into a SOFR 澳洲幸运5官方开奖结果体彩网:interest rate swap.

The c൲ompany swaps its floating-rate loan for a fixed-rate loan with Bank A, a counterpartꦿy. XYZ agrees to pay a fixed rate of 3.75% and receive a floating three-month term SOFR.

If SOFR rises above 3.75%, the swap reduces XYZ's costs. If SOFR falls below 3.75%, the swap results in a net cost.

The Bottom Line

SOFR has firmly established itself as the go-to benchmark for USD-denominated financial instruments, replacing LIBOR with a more transparent, reliable, and transaction-based approac♛h.

While the transition had so💖me challenges, including the lack of a built-in credit risk part and the initial absence of term structures, market changes like introducing term SOFR and spread adjustments have ꧂smoothed adoption.