SOFR Futures and Options

CHAPTER 5SOFR Future Options

The move from LIBOR to SOFR as reference rate implies a fundamentally new concept: Rather than using a term rate, we apply a daily rate. But SOFR futures combine the daily rates during their reference period into a (forward) term rate. Hence, when dealing with SOFR futures, the situation is similar to LIBOR; in a manner of speaking, one might say that SOFR futures transform the daily rates during their reference period into a term rate like LIBOR. And this is the reason behind the relatively easy transfer of concepts to the new reference rate. Via SOFR futures one does not need to deal directly with daily SOFR, but with the daily SOFR aggregated by the future.

However, once the SOFR futures contract enters its reference period, this aggregation ends and together with it the similarity to LIBOR and the direct transfer of concepts from the Eurodollar (ED) futures market. (Compare Figure 2.1.) As soon as the reference period starts, one needs to deal with daily SOFR values. When only the rate itself is concerned, this can be achieved by some straightforward adjustments for the front-month contract, discussed in Chapter 2 (e.g., for calculating the strip rate and executing the roll). But when volatility is also involved, the end of aggregation at the beginning of the reference period results in a completely new type of option. Before the reference period, options on SOFR futures have a forward term rate as underlying, as do options on ED contracts. ...