SARON hedging strategies

Hedging of SARON exposure, Part II

SARON hedging strategies

On 5 March 2021, the Financial Conduct Authority (FCA) announced the official dates of the cessation and loss of representativeness of the LIBOR rates. As a result, 31 December 2021 will be the last day on which the CHF LIBOR will be published. During the last months, a multitude of informative documents were provided by the Alternative Reference Rates Committee (ARRC) and the International Swaps and Derivatives Association (ISDA). As a follow-up from the previous article Hedging of SARON exposure, Part I: Explanatory power of SARON term and actual rates, this article assesses the different compounding methodologies with respect to hedging strategy.

Hedging strategies

The first SOFR Symposium1 discussed the different types of exposures of loans that are based on either term rates or compounded rates. It was concluded that it is generally operationally easier and cheaper to hedge a SOFR compounded exposure of loans rather than a SOFR term rate exposure. Dealers may offer term SOFR derivatives, but they will have to use more hedging instruments to hedge the term exposure. The associated additional costs will also have to be passed on. Substituting SOFR with SARON, the same notions can be applied. In other words, it is operationally easier and cheaper to hedge a compounded SARON exposure rather than SARON term rate exposure. This will be explained in this article by three cases of loans with different exposure characteristics.

Case 1: Hedging a 12-month Fixed SARON Term Rate Loan with Quarterly Payments (using two hedge instruments)

The loan in Figure 1 does not exist in the market, but is artificially created to understand the difference in hedge strategy between a loan based on a term rate (i.e., forward-looking rate) and one based on a compounded rate (i.e., backward-looking rate). It is possible to perceive the loan as a payer interest rate swap for which the lender, for example the bank, pays the fixed cost for borrowing money. This cost can be seen as the cost of borrowing cash in the CHF money market, e.g. via repo agreements, which is the market used to derive daily SARON rates. For this reason, the lender ends up paying a 12-month SARON fixed rate at maturity of the financing transaction (after 12 months) and receiving a 3-month SARON term rate each quarter. The term rate is known at the start of each quarter and received at the end, i.e. the 3-month SARON term rate is known at time t0 but received at time t+3m.

Finally, it is useful to remind that the SARON term rate structure is derived from the fixed-leg of SARON OIS swaps. Using two hedge instruments, shown in Figure 2 and Figure 3 below, it will be possible to synthetically create a term rate from a series of SARON overnight indexed swaps (OIS) with different maturities, which we will explain next.

Figure 1 – 12-month fixed SARON Term Rate Loan with quarterly reset. The lender pays a SARON 12-month and receives a quarterly SARON 3-month term rate.
The SARON 3-month term rate is known in advance at the previous quarter since it is a forward-looking rate.

Hedging the SARON term exposure of the loan requires the following:

  • Hedge instrument 1 (Figure 2): Enter into a 12-month receiver SARON OIS swap at the start of the loan to [a] receive a fixed 12-month SARON rate, offsetting the 12-month SARON payment of the financing transaction, and [b] pay a floating quarterly compounded SARON (plain in arrears) rate.
  • Hedge instrument 2 (Figure 3): At the start of each quarter, enter into a 3-month SARON OIS swap to receive the floating-leg 3-months compounded SARON (plain in arrears) rate, used to pay the quarterly compounded SARON payments of hedge instrument 1. In addition, the buyer also pays the 3-month SARON term rate through the quarterly received 3-month SARON term rate of the loan (Figure 1). This is possible because, in a liquid market, the SARON 3-month term rate is derived from the fixed leg of several 3-month SARON OIS swaps.

Figure 2 – 12-month SARON OIS contract which pays quarterly compounded SARON (plain in arrears) and receives 12-month fixed SARON.

Figure 3 – 3-month SARON OIS contract which pays fixed 3-month SARON and receives quarterly compounded SARON (plain in arrears).

Case 2: Hedging a 12-month Fixed SARON Quarterly Compounded Loan with In Advance Payments (using 1 hedge instrument)

Like the previous loan, it is possible to see this loan as a payer interest rate swap. For this reason, Figure 4 shows the lender paying a SARON 12-month fixed rate at maturity (after 12 months) and receiving a 3-month SARON compounded in advance (last reset) each quarter. The 3-month SARON rate is known at the start of each quarter and received at the end, e.g. the 3-month SARON compounded in advance (last reset) rate is known at time t0 (i.e. calculated over time t-3m and t0), but received at time t+3m.

Figure 4 – 12-month fixed SARON loan with quarterly compounded last reset in advance payments. The lender pays a 12-month SARON and receives a quarterly compounded plain in arrears 3-month SARON rate. The 3-month SARON rate compounded in advance (last reset) is known in advance at the previous quarter, even if it is a backward-looking rate.

Hedging the SARON (in advance) exposure of the loan requires the following:

Hedge instrument 1 (Figure 5): Enter into a 12-month receiver SARON OIS swap at the start of the loan to [a] receive a fixed 12-month SARON rate, used to pay the 12-month SARON rate of the financing transactions, and [b] pay a floating quarterly compounded SARON (plain in arrears) rate with the quarterly received 3-month SARON compounded (in advance) rate from the loan.

 

Figure 5 – 12-month SARON OIS contract which pays quarterly compounded SARON (plain in arrears) and receives fixed 12-month SARON.

This hedge strategy results in a mismatch (a shift) of 3 months, since the 3-month SARON rate is calculated plain in arrears, whereas the loan is calculated in advance (compare Figure 4 with Figure 5). The received fixed-leg of the OIS swap offsets the payment of the 12-month SARON fixed rate of the financing transaction. However, the floating rate component of the loan differs from the floating-leg component of the OIS swap (hedge), namely:

In short, this is not perceived as a perfect hedge due to the mismatch between the received and paid amounts. From a lenders perspective, by offsetting the payments during the length of the loan, the result is the difference between the first payment received and the last payment done (highlighted in red in the table). This basis risk can be passed on to the client by an extra margin on the top of the compounded SARON in advance rate. This premium can be considered the ‘price’ that the client needs to pay for knowing the interest rate in advance.

Case 3: Hedging 12-month SARON loan with quarterly compounded in arrears payments (using 1 hedge instrument)

Again, it is possible to perceive the loan as a payer interest rate swap. For this reason, Figure 6 shows the lender paying a 12-month fixed SARON rate at maturity (after 12 months) and receiving a 3-month compounded SARON plain in arrears rate each quarter. The 3-month SARON rate is both known and received at the end of each quarter, i.e. the 3-month SARON rate compounded plain in arrears is known and received at time t+3m.

Figure 6 – 12-month fixed SARON loan with quarterly compounded plain in arrears payments. The lender pays a 12-month SARON rate and receives a quarterly compounded plain in arrears 3-month SARON rate. The 3-month SARON rate compounded plain in arrears is known in arrears at the payment date since it is a backward-looking rate.

Hedging the SARON (in arrears) exposure of the loan requires the following:

Instrument 1 (Figure 7): Enter into a 12-month receiver SARON OIS swap at the start of the loan to [a] receive a fixed 12-month SARON rate, used to pay the 12-month SARON rate of the loan, and [b] pay a floating-leg quarterly compounded SARON (plain in arrears) rate with the quarterly received 3-month SARON compounded (plain in arrears) rate from the loan.

Figure 7 – 12-month SARON OIS contract which pays quarterly compounded SARON (plain in arrears) and receives fixed 12-month SARON.

The hedge strategy applied to the loan in Figure 6 is a full hedge without creating additional basis risk.

Conclusions regarding hedging strategies

The table below summaries the three types of loans and their respective hedge strategies:

The current market practice for compounding the new reference rates to be applied to cash products is to calculate the rates five working days prior to the interest payment date (i.e. compounding in arrears look back five days), based on a rate compounded over a period starting and finishing five (business) days before the interest period begins and ends. In this circumstance, an institution may be able to assess from a qualitative perspective that there is no material change to the time value of money for a hedging prospective. For this reason, it is possible to assert that the banks are already accepting the basis risk created by the five days shift.

Moreover, if a liquid market for SARON term rates is considered (which is currently not the case), the market would move every second, making the timing of fixing very difficult to check and so the exact value of the instrument would be impossible to identify. It is possible to make it transparent by using the ISDA fixing, which is known, but this common protocol should be accepted by the whole market. After making the value of the instruments transparent, the cost and operational overloading of the hedging strategy are still much higher for a loan based on SARON term rates than for a loan based on SARON compounded in arrears.

References
1) Mastromarco, D., Wernert, P., Wycisk, M. Hedging of SARON exposure, Part I. SARON term rates vs SARON actual rates. May 2021
2) ARRC. Insights from National Working Group Chairs. March 2021.
3) National Working Group on Swiss Franc Reference Rates. Discussion paper on SARON Floating Rate Notes. July 2019.
4) National Working Group on Swiss Franc Reference Rates. IBOR to RFR transition: Effects on financial reporting. July 2019.
5) SIX, Swiss Average Rate Overnight. The new Swiss franc benchmark. 2018.