Definition of Secured Overnight Financing Rate (SOFR)

Herein, you will find all you need to know about the Definition of Secured Overnight Financing Rate (SOFR) Category. Definition of Secured Overnight Financing Rate (SOFR) Category A recap of the Secured Overnight Financing Rate background. Secured Overnight Financing Rate transitory issues and more.

Definition Of SOFR (Secured Overnight Financing Rate)?

Th is a criterion for the London Interbank Offered Rate for investment derivatives and loans (LIBOR). In October 2020, interest rate swaps on more than $80 trillion in notional debt were transferred to the SOFR. Long-term liquidity is likely to increase as a result of this transformation. While short-term trading instability in derivatives is expected to increase significantly.

The Secured Overnight Financing Rate: A Recap (SOFR)

SOFR is a key interest rate used by banks to price derivatives and loans dollar-based. The daily secured overnight financing rate (SOFR) is based on Treasury buyback trading activity. It dealers provide banks with overnight loans backed by their bond holdings.

Interest-rate swaps, which businesses and other parties employ to manage interest-rate risk. It used to speculate on changes in borrowing costs, rely on benchmark rates like the SOFR.

Secured Overnight Financing Rate Background

Interest-rate swaps are agreements in which the parties exchange fixed-rate interest payments for floating-rate interest payments. In a “vanilla” swap, one party agrees to pay a fixed interest rate, and, in exchange, the receiving party agrees to pay a floating interest rate based on the SOFR—the rate may be higher or lower than the SOFR, based on the party’s credit rating and interest-rate conditions.

In this case, the payer benefits when interest rates go up, because the value of the incoming SOFR-based payments is now higher, even though the cost of the fixed-rate payments to the counterparty remains the same. The inverse occurs when rates go down.

Secured Overnight Financing Rate Background (SOFR)

The LIBOR has served as the benchmark interest rate for investors and banks when negotiating credit consensus. Since it was established in the mid-1980s. The LIBOR is calculated by calculating the average interest rate at which major global banks loan money to one another. It consists of five currencies and seven maturities. The five currencies are the US dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss franc (CHF). The three-month US dollar rate (generally referred to as the current LIBOR rate) is the most widely mentioned.

Due to the financial crisis of 2008, regulators became apprehensive about putting too much confidence in the benchmark. For one example, the LIBOR is mostly based on estimations from surveyed global banks, rather than actual transactions. When it was exposed in 2012 that more than a dozen financial institutions fudged their data in order to earn more from LIBOR-based derivative products, the consequence of granting banks that much leeway became clear.

Furthermore, post-financial-crisis banking regulations reduced interbank borrowing, prompting some regulators. This is to express worry that the restricted volume of trading activity has rendered the LIBOR even less credible. After 2021, the British authority that compiles LIBOR rates states that banks will no longer be required to disclose interbank lending data. This change prompted developed countries all around the world to scramble to identify a new reference rate that could someday take its place.

The Federal Reserve (Fed) reacted in 2017 by forming the Alternative Reference Rate Committee, which included many significant banks, to choose an alternative reference rate for the US. The secured overnight financing rate (SOFR), an overnight rate, was chosen as the new benchmark for dollar-denominated contracts by the committee.

LIBOR vs. SOFR

The LIBOR Treasury repo market has substantial trading—roughly 1,500 times that of interbank loans as of 2018—making it a more accurate indication of borrowing prices in theory.

Unlike LIBOR, the (SOFR) is based on data from observable transactions rather than projected borrowing rates.

Making the Switch to Secured Overnight Financing (SOFR)

For the time being, LIBOR and SOFR will cohabit for the time being. So, it is projected that the latter will overtake the LIBOR as the leading benchmark for dollar-denominated derivatives and credit instruments in the coming years.

The Federal Reserve said on November 30, 2020, that LIBOR would be phased out and soon replaced by June 2023. According to the same notice, banks were told to stop writing LIBOR contracts by the end of 2021. According to the same notice, all LIBOR contracts should be completed by June 30, 2023, according to the same notice.

Issues Of Transitory

Switching to a new benchmark rate is challenging since there are trillions of dollars in outstanding LIBOR-based contracts, some of which due to maturity until the LIBOR is retired. This covers the commonly used three-month US dollar LIBOR, linked to over $200 trillion in debt and agreements.

Because there are multiple significant disparities between the two interest rates, revaluing contracts is difficult. The LIBOR, for example, indicates unsecured loans, but the SOFR, which reflects loans guaranteed by Treasury bonds (T-bonds), is a risk-free rate. Furthermore, the LIBOR has 35 separate rates, but the SOFR only releases one rate that is based solely on borrowed money.

The transition to the SOFR will have the greatest impact on the derivatives market. It will benefit consumer credit products like adjustable-rate mortgages and personal student loans, as well as debt instruments like commercial paper.

The rise of the benchmark rate impacts how much debtor will pay once the fixed-interest period of their loan ends in the event of an adjustable-rate mortgage based on the SOFR. When the loan “resets,” if the SOFR is higher, property owners will pay a higher rate.

Particular Points to Consider

Options LIBOR rate been sought other nations. The sterling overnight index average (SONIA), an overnight lending rate, was chosen as benchmark for sterling-based contracts in future by the U.k.

The European Central Bank (ECB) chose the euro overnight index average (EONIA), centered on unsecured overnight loans, whereas Japan will use its own rate, known as the Tokyo overnight average rate (TONAR). Vie with $100,000 in virtual cash without taking any risks. Use our free stock picker to put your trading talents to the test. Vie against hundreds of other traders on Investopedia and trade your way to the top! Before you start risking your own money, practice trading in a simulated environment. Practice trading tactics so that you are prepared to enter the real market when the time comes.

How Does LIBOR (London Interbank Offered Rate) Function? in the worldwide interbank market for short-term loans. LIBOR is a standard interest rate at which major global banks borrow from each other.

Singapore Interbank Offered Rate (SIBOR) The Singapore Interbank Offered Rate (SIBOR) is a benchmark interest rate used by banks in Asian time zones to lend to each other.

The LIBOR scandal, which came to light in 2012, involved a scheme by bankers to manipulate the London Interbank Offered Rate (LIBOR) for profit. 

Euro LIBOR London Interbank Offered Rate is denominated in euros, which banks offer each other for large, short-term loans. 

The Hong Kong Interbank Offered Rate (HIBOR). The Hong Kong Interbank Offered Rate (HIBOR) is the Hong Kong dollar-based interest rate benchmark for lending between banks in the Hong Kong market. 

Adjustable-Rate Mortgage (ARM). An adjustable-rate mortgage (ARM) is a mortgage with a variable interest rate linked to a certain benchmark.

Definition of Secured Overnight Financing Rate (SOFR)Category

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