SOFR Futures and Options

CHAPTER 7Simple Examples of Hedging with SOFR Futures

In the first half of the book, we focused on the concepts underlying the SOFR futures and options complex, including the repo market, the construction of SOFR, and the specifications and characteristics of SOFR futures and options. In the second half of the book, we focus on practical applications of SOFR futures and options, with an emphasis on specific, worked examples.

In general, SOFR futures and options provide a useful way to manage SOFR risk. But as we consider specific examples, we'll see that it's particularly important in each case to define the terms manage and SOFR risk. For example, one money market fund manager may be interested in minimizing the standard deviation of the net asset value of his fund as of a specific target date, while another money market fund manager may be concerned only with minimizing the downside risk to the NAV of his fund. A corporate treasurer may be interested in using SOFR futures to convert daily rate risk to quarterly rate risk in a cash management program, while a hedge fund trader may be interested in maximizing the Sharpe ratio of a spread trade involving SOFR futures, without knowing the date on which he'll exit the position.

As we work through specific examples, we'll see that the term SOFR risk often entails a collection of risks that differ depending on the context. For example, a bank that wishes to use SOFR futures to convert the risk in a SOFR floating rate note from daily ...