SOFR Futures and Options

CHAPTER 1SOFR

THE REPO MARKET

The Secured Overnight Financing Rate (SOFR) is based on data collected from the market for overnight repurchase agreements (i.e., the repo market). A repo transaction is a loan collateralized by a bond, usually of very high quality, such as a US Treasury note. Since a repo agreement is a secured loan, the interest rate associated with a repo transaction is usually lower than interest rates for otherwise similar unsecured loans, such as LIBOR.

This difference also leads to a lower Bank for International Settlements (BIS) risk weighting (e.g., 0% for US Treasuries) and thereby to lower capital costs (Huggins and Schaller 2013, p. 148). Hence, the motivation for the borrower in the repo market is the lower interest rate that can (usually) be obtained with a secured financing. The motivation for the lender in the repo market is the significant reduction of credit risk and a lower cost of capital.

In addition, lenders may be motivated to receive a specific bond as collateral in the repo transaction in order to cover a short position in this bond. The fact that the repo market can be used to cover short positions makes it a vital component of many relative value trades – and therefore the repo rate appears in many relative value relationships and arbitrage equations. For example, the “classical” relative value trade of buying a bond futures contract and selling a bond deliverable into that contract requires covering the short position in the bond until ...