SOFR Futures and Options

CHAPTER 10Hedging Caps and Floors with SOFR Futures Options

We highlighted in Chapter 5 the interconnected problems of a missing theoretical pricing approach and of missing market liquidity for options on SOFR futures. The first problem makes it impossible to simply transfer the hedging concepts from Eurodollar (ED) futures options. While in Chapter 9 we described how to hedge a SOFR OIS with a strip of SOFR futures in the same manner as one hedges a LIBOR-based swap with a strip of ED contracts, that approach requires major modifications for hedging a cap or floor on SOFR. The second problem makes it impossible to test any hedges constructed with options on SOFR futures in the same manner as we did for the bond hedge with a SOFR futures strip (Figure 9.4), among others.¹

Despite these problems, this chapter intends to give some practical advice for hedging caps and floors with options on SOFR futures. While one cannot expect the hedge to be as easy and well-fitting as in case of LIBOR-based products, one can try and make the best of a difficult situation by dividing the hedging strategy conceptually according to the two fundamentally different stages explained at the beginning of Chapters 2 and 5:

• Before their reference period starts, SOFR futures function as aggregators of daily SOFR values into a (forward) term rate and hence the options on them work just like those on ED contracts. Here, the concepts can again be simply transferred to caps and floors based on the new reference ...