CurveGlobal Interest Rate Derivatives SONIA Futures: New Opportunities Andy Shaw and Dr. Mark Tomsett, Links Risk Contents 1 Introduction 2 2 What is SONIA? 2 2.1 The End of LIBOR? 2 2.2 How is it calculated? 2 2.3 How is it used? 3 2.4 What is an OIS? 3 2.5 What influences OIS rates? 5 3 SONIA Futures 6 3.1 Contract Specifications 6 3.2 Basis Point Value 7 3.3 Futures vs OIS 7 3.3.1 Convexity: An Introduction 8 3.3.2 Convexity: In Detail 9 3.3.3 Monetising Convexity 9 3.4 Spread Trading Strategies 10 3.5 Managing Portfolio Delta Risk 10 4 Miscellaneous Items 13 4.1 Liquidity 13 4.2 Margin Efficiency 13 5 Summary 14 6 Definitions 15 References 16 Disclaimer 17 curveglobal.com | linksriskadvisory.com 1 1 Introduction This note takes a look at the creation of interest rate exposure using exchange traded derivatives, in particular the SONIA-indexed futures contract. Given the regulatory driven changes that are starting to facilitate switches away from benchmarks like LIBOR, and with benchmarks like SONIA for GBP denominated derivatives gaining in popularity, there is increased demand for new products referencing this key index and information explaining their behaviour. 2 What is SONIA? 2.1 The End of LIBOR? From the end of 2021 the Financial Conduct Authority (FCA) will no longer compel panel banks to submit London Interbank Offered Rate (LIBOR) estimates. Some evidence¹ suggests that the underlying market for unsecured interbank overnight lending, which LIBOR purports to measure, is no longer sufficiently liquid. In addition, the EU Benchmark Regulation introduced in 2018, which necessitates benchmarks to represent the underlying market being measured, further requires that input data based on discretion and expert judgment be subject to enhanced procedures and controls. As some LIBOR panel banks provide input based on expert judgment alone, panel banks may consider the legal and regulatory risks too great to continue submissions once no longer compelled to do so. In April 2017 the Bank of England (BoE) Risk Free Working Group selected the Sterling Overnight Index Average (SONIA) as its proposed alternative benchmark. 2.2 How is it calculated? SONIA, originally introduced in 1997, has been administered by the BoE since 2016, and in a modified form since April 2018. It is²: A measure of the rate at which interest is paid on sterling short-term wholesale funds in circumstances where credit, liquidity and other risks are minimal. It is the trimmed, volume-weighted mean of interest rates paid on eligible sterling denominated deposit transactions. Eligible transactions have to meet the following conditions: to be reported within a specific time-frame, unsecured and of one business day maturity, executed within 00:00 and 18:00 UK time and have a minimum notional value of £25 million. 1See [4] and [7] 2See [1] curveglobal.com | linksriskadvisory.com 2 2.3 How is it used? Overnight benchmarks, like SONIA, are generally referred to as overnight indexed swap (OIS) rates, because they are used primarily for the settlement of interest rate swaps. They are also important in determining the amount of cash that is paid on collateral posted to secure over-the-counter (OTC) derivative liabilities between counterparties. For example, a central counterparty (CCP) will transfer money between two members to reflect changes in mark-to-market (MtM) on a daily basis. If a transaction moves in favour of one member they will receive in their collateral account a cash amount, known as variation margin (VM), equal to the change in value. This amount is debited from the collateral account of the other member. The VM recipient is required to pay what is known as Price Alignment Interest (PAI) to the VM payer. PAI is usually set using an overnight index. 2.4 What is an OIS? An OIS is an interest rate-sensitive derivative, very similar to a standard interest rate swap (IRS) but with one important difference: the determination of the floating rate. An IRS will have a single (IBOR-based) fixing per floating rate period that determines the relevant cashflow. This means that the payment can be brought forward because, once the IBOR rate index is published at the start of the period, the cashflow is known and can be paid at any point. The same does not apply to an OIS, where all the daily fixings over the floating rate period are required before the final payment is known. OIS tend to have annual fixed payments and annual floating frequencies³. That means something in the order of 252 separate fixings. This has implications for how the final leg is calculated and the relationship between the fixing date, the publication date, the effective date and the maturity date. The floating leg payment for the single period of an IBOR- indexed IRS is dependent on the information shown in Figure 1. The fixing date and publication date are the same day. The start date (for the calculation of the accrual) will either be the same day or one or two days later, depending on the currency convention. Note that the settlement takes place on the start date. Figure 1: IBOR Floating Leg Schedule 3Or single payments at maturity for those with a tenor of less than 1 year. curveglobal.com | linksriskadvisory.com 3 For a SONIA-indexed swap, for a given fixing date, the publication date is the next good business date at 09:00. The effective date is the fixing date and the maturity date is the next good business date. For SONIA-indexed swaps there is no lag between the maturity date and the settlement date. The final payment is generated by compounding the overnight interest rate over the whole floating period. Equation 1 shows the calculation of the fixed leg (left-hand side) and the floating leg (right-hand side) of a single payment OIS. Where: TE = start date of the swap TM = maturity date of the swap TS = settlement date of the swap ROIS = OIS rate D = day count basis ri = the overnight rate on day i ni = the number of days over which ri compounds DFTS = discount factor to date TS ∏ = the product of a sequence of numbers ni will typically be equivalent to 1 day but over a weekend, or holiday, may be longer. curveglobal.com | linksriskadvisory.com 4 Figure 2: OIS Floating Leg Schedule The term in the square brackets of equation 1 is the compounded SONIA rate. The compound rate ( r˜ ) equivalent to the individual SONIA fixings can be calculated using equation 2. For example, assume that a floating leg is based on three SONIA fixings published on Friday, Monday and Tuesday. The fixings are 1.5%, 1.55% and 1.6% respectively. The compound rate between Friday and Wednesday is calculated as: Notice how, due to the weekend, the first fixing applies over three days rather than just one. Weekends and official holidays, for example Easter, can increase the importance of fixings over these periods, particularly for shorter dated trades. 4 The payment of this leg takes place on the last publication date of the index , so TM = TS. The timeline of a single fixing of a generic OIS floating leg is shown in Figure 2. 2.5 What influences OIS rates? As indicated in section 2.2, unlike LIBOR, SONIA is calculated from actual transactions. The qualifying transactions are only those made by ‘recognised’ banks: those who have been approved by the BoE to use its lending and deposit facilities. It is the rate that is paid on overnight deposits to these banks that is a key determinant of other short-term interest rates. Theoretically, being backed by the BoE, it should represent a virtually risk-free rate and act as a floor to all other rates. However, there are some institutions who would like to use the BoE deposit facilities but are unable due to being ‘unrecognised’. Instead they deposit funds with recognised banks who in turn deposit with the central bank. In order to profit from this situation the recognised bank will offer the lender a rate below the BoE deposit rate. When the supply of liquidity from unrecognised banks falls, the rate offered will rise. Therefore, by a quirk of the UK market structure, as the supply of funds fluctuates, SONIA can trade above and below the BoE deposit rate5. 4In other currencies this payment may take place with a lag, which introduces a potential convexity issue. This has been shown to be negligible. See [6]. 5See [3] for a more detailed discussion. curveglobal.com | linksriskadvisory.com 5 3 SONIA Futures 3.1 Contract Specifications On 30th April 2018 CurveGlobal6 (CG) launched its Three-month SONIA Futures contract. The contract specification has the following key features7: • SONIA indexed. • Contract Notional £500,000, Fixed Tick Size 0.005, Tick Value £6.25. • Accrual Period - The contract month’s International Money Market (IMM8) date to the day before the next IMM date. » For example, the June contract accrual will start on the June IMM date and end on the September IMM date. • The contract will expire/mature on the third Wednesday of the IMM month. • The EDSP9 of the futures contract is 100 – R, where R is based on the compounded SONIA rate over the Accrual Period. One of the attractions of the Three-month SONIA futures contract is that it has been deliberately designed in a way that replicates the floating leg construction of the SONIA OIS. 6CurveGlobal is an interest rate derivatives venture between the London Stock Exchange Group, the Cboe and a number of the major dealer banks.