GTreasury Logo
Back to Blog

LIBOR Transition: Assessing Indirect Valuation Impacts

The direct impacts of the transition away from LIBOR to the use of an alternative reference rate such as the Secured Overnight Financing Rate (SOFR) have been well publicized. ISDA and ARRC have been releasing regular updates and suggested fallback language to determine how LIBOR rates will be replaced in derivative and loan agreements, once LIBOR is no longer available. However, LIBOR’s sunset will have impacts beyond financial contracts that reference the index itself. One of these is financial instrument valuation, where LIBOR and LIBOR swap rates are frequently used as the benchmark curve for the calculation of discount factors used to present value a derivative’s cash flows.

Financial Instrument Valuation

Come the end of 2021 (or sooner if market liquidity evaporates before then), LIBOR rates will no longer be available as inputs to valuation models. So – what curves should be used? Typically for derivatives utilized by nonfinancial end-users, there is no collateral requirement, and the discounting curve used to present value derivative cash flows should reflect an uncollateralized rate (like LIBOR). SOFR is a secured rate, so it would not be appropriate for valuation of uncollateralized derivative positions. The 5-year historical SOFR-LIBOR median spread, which is expected to be incorporated into fallback language in swap agreements, could be applied to a SOFR curve that is used as an input to valuation models. At best, that may be a stopgap measure since the spread is designed to be value neutral when legacy contracts are switched from LIBOR to SOFR, and not a spread that could be used indefinitely as an adjustment to a SOFR curve.

Credit Valuation Adjustment

Similarly, the appropriate calculation of a credit valuation adjustment (CVA) is expected to change. There are various approaches to calculating CVA and most approaches use a spread indicative of an entity’s nonperformance risk to either incrementally discount cash flows, or as an input to a potential future exposure calculation. These spreads may be based on the spread to LIBOR recently negotiated in a credit agreement, a spread based on a current bond yield, or a credit default swap rate, which may be considered a spread over the LIBOR swap curve, which reflects an entity’s credit risk. When the benchmark curve changes, these spread adjustments will also need to be changed, so that the credit adjusted valuation is not impacted by the transition away from LIBOR based in inputs.

Call To Action

While there is still time to adapt, derivative users should consider these secondary impacts that LIBOR transition will have, beyond the effects on LIBOR indexed instruments. The auditors will continue to require independent derivative valuations. That means using counterparty statements in lieu of addressing these changing market conditions isn’t going to be viable alternative.

To start a conversation or learn more about this topic, click here. We are available to assist with your needs related to LIBOR transition.

Subscribe to Our Newsletter

Stay in the know: Get the latest on our events, digital trends and how they are impacting your industry, and what it means for the future of business.