Canales Saavedra, Antonio Victor

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  • Publication
    How is SOFR different from LIBOR?
    (2021-01-01) Canales Saavedra, Antonio Victor
    SOFR is expected to phase out USD LIBOR in the near future. The two rates are intrinsically different and are affected by various idiosyncratic features. Recently, the relevance and long-term effects of these differences have received increased academic interest. I begin by synthesizing the literature on meaningful ways in which the two rates are distinct. Then, I contribute to this knowledge by studying the SOFR-LIBOR spread more closely. Fundamentally, LIBOR includes term structure and risk SOFR lacks, and the rates have underlying markets of drastically different liquidity. I regress the daily spread of 1M LIBOR and 3M LIBOR to overnight SOFR on metrics for liquidity, term structure and credit risk, achieving significance on all three variables. I also regress a monthly average of the above spreads on monthly averages of the above metrics, as well as other relevant economic variables. Results show the spread is also significantly affected by variables measuring economic outlook, equity market volatility, monetary policy, and treasury trading volumes. These findings suggest a framework to understand the ways in which SOFR and LIBOR differ more precisely, and support observations by other academics that LIBOR and SOFR behave very differently under extreme economic circumstances.