hard · FRM Part 2 Current Issues
During the USD LIBOR-to-SOFR transition, a desk holds a legacy swap that referenced 3-month USD LIBOR and was amended to fall back to compounded-in-arrears SOFR plus the ISDA fixed spread adjustment. The treasurer is puzzled that, even with the spread adjustment, residual basis and behavior differ from the old LIBOR leg.
Which statement MOST accurately characterizes the irreducible economic difference that the fixed ISDA spread adjustment does NOT eliminate?
- LIBOR was a forward-looking term rate embedding bank credit and term premia set at period start, whereas compounded-in-arrears SOFR is a backward-looking near-risk-free rate known only at period end, so the fixed spread corrects the median historical level but not the dynamic, state-contingent credit-sensitivity and timing of the cash flow.
- The spread adjustment is reset daily to the prevailing LIBOR-SOFR gap, so any residual basis the treasurer observes must stem from a data error in the fallback calculation rather than a genuine economic difference.
- Compounded-in-arrears SOFR is itself a forward-looking term rate, so the only remaining difference is the day-count convention, which the ISDA spread does not adjust.
- Because SOFR is secured and LIBOR unsecured, the fixed spread fully internalizes the credit differential at all times, leaving only a negligible difference attributable to collateral haircuts.
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