Client:
Corporation taking out a loan
Challenge:
Hedge exposure to fluctuating interest rates
Solution:
SOFR strips
Overview
Loans are often based on a term rate plus a fixed premium. When the interest rate resets at different points throughout the life of a loan, market participants are exposed to the risk of rising or falling rates between each reset date. A SOFR strip is defined as a series of consecutive quarterly SR3 futures contracts.
Approach
In this scenario, it is March and a corporation anticipates borrowing $100 million for two years at three-month Term SOFR plus a fixed premium, reset quarterly. The corporation already knows the rate for the first 90 days, but they remain exposed to the risk that rates will rise during the seven following quarterly loan reset dates.
The two-year loan can be decomposed into seven quarterly strips. The corporation can sell three-month SOFR futures (SR3) in order to hedge the risk of rising rates.
To determine how many futures contracts to sell, the corporation will first determine the BPV of the loan, then use that to construct a hedge ratio.
BPV = $100,000,000 x (630/360) x 0.01% = $17,500
HR = $17,500 / $25 = 700 SR3 sell to hedge risk
Since the floating rate loan can be thought of as seven successive 90-day loans, the BPV and hedge ratio could also be calculated on an individual loan level.
BPV = $100,000,000 x (90/360) x 0.01% =$2,500
HR = $2,500 / $25 = 100 SR3 sell per loan to hedge risk
The corporation hedges each loan period separately by selling a strip of three-month SOFR futures.
RESET DATE | ACTION |
---|---|
White June | Sell 100 White Jun futures |
White September | Sell 100 White Sep futures |
White December | Sell 100 White Dec futures |
White March | Sell 100 White Mar futures |
Red June | Sell 100 Red Jun futures |
Red September | Sell 100 Red Sep futures |
Red December | Sell 100 Red Dec futures |
Results
In this scenario, the corporation’s hedge is evenly distributed along the forward curve to hedge future potential rate increases.
Conclusion
SOFR futures can be used in succession (strips) to manage interest rate risk. Since SOFR futures cover 90-day periods, the number of contracts needed to cover the length of the loan will grow as the loan term increases. Because of this, strips can be also packaged into packs and bundles to allow for the purchase or sale of multiple strips in a single transaction.
Find your solution
Let CME Group help you find a solution to your challenge.
Interested in learning more about packs and bundles? Check out this article:
SOFR Futures Packs and Bundles
Learn more about SOFR in this course:
Introduction to SOFR
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