SOFR Futures and Options

CHAPTER 6Pricing Biases and SOFR Curve Building

A prerequisite for a successful transition from LIBOR to SOFR is that market participants are able to construct a term structure of SOFR interest rates extending years into the future, making it possible to price SOFR loans, swaps, swaptions, caps, and similar instruments tied to SOFR rates over time. And given their relative liquidity, SOFR futures are an integral component in the construction of a SOFR term structure. In fact, for now, SOFR futures are often the only set of instruments used to construct a yield curve for the SOFR complex.

Market participants familiar with the LIBOR complex will be familiar with the key role that Eurodollar futures prices have played in the construction of LIBOR curves. And as part of that experience, they're likely to be familiar with the convexity bias attributed to Eurodollar futures. In particular, every quant worth his salt learns to adjust the prices of Eurodollar futures for this bias before using these prices as inputs to his LIBOR curve-building algorithm.

So before delving into the minutiae of SOFR yield curves, we'll consider whether SOFR futures might suffer from any similar biases that would require adjustment before using their prices to construct a SOFR term structure. And as a first step in that process, we'll review the situation for Eurodollar futures.

BIASES IN EURODOLLAR FUTURES PRICES

When considering potential biases afflicting SOFR futures prices, it's useful to remind ...