##### Client:

Corporation taking out a loan

##### Challenge:

Hedge exposure to fluctuating interest rates

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.

SOFR Futures Packs and Bundles

Introduction to SOFR

U.S. 2023 Disclaimer

Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade.

CME Group, the Globe Logo, CME, Globex, E-Mini, CME Direct, CME DataMine and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. CBOT is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is a trademark of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. All other trademarks are the property of their respective owners.

The information within this communication has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. CME Group does not represent that any material or information contained in this communication is appropriate for use or permitted in any jurisdiction or country where such use or distribution would be contrary to any applicable law or regulation.

Additionally, all examples in this communication are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and superseded by official CME, CBOT, NYMEX and COMEX rules. Current rules should be consulted in all cases concerning contract specifications.