hard · FRM Part 2 Current Issues

Which statement MOST accurately characterizes the irreducible economic difference that the fixed ISDA spread adjustment does NOT eliminate?

1. 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.
2. The spread adjustment resets daily to track the prevailing LIBOR-SOFR gap observed in the underlying reference panel data each morning, so any residual basis the treasurer now observes must stem from a data feed or calculation error in the fallback methodology rather than any genuine underlying economic difference between the two rates.
3. Compounded-in-arrears SOFR is itself effectively a forward-looking term rate once the daily compounding is applied across the full accrual period each quarter, so the only difference remaining after the fallback amendment is a minor day-count convention mismatch that the fixed ISDA spread adjustment does not correct at all under any circumstance.
4. Because SOFR is a secured overnight rate and LIBOR was an unsecured, forward-looking term rate embedding bank credit risk, the fixed spread fully internalizes the entire credit differential between the two benchmarks at all times, leaving only a negligible residual tied to collateral haircuts and margining costs on the underlying swap trade.

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