How has the SOFR transition from LIBOR changed swap pricing?

Question

AcadiFi · Accepted Answer

The SOFR transition fundamentally reshaped swap mechanics. Key differences to know:

1. SOFR is a secured overnight rate (Treasury repo collateral), while LIBOR was an unsecured term rate polled from banks. SOFR has no bank credit component.

2. SOFR is backward-looking, computed in arrears from actual overnight fixings. LIBOR was forward-looking — the rate for the period was known at the start.

3. Term SOFR exists (1M, 3M, 6M published by CME) and is used for retail loans. But cleared derivatives primarily use Compounded SOFR in Arrears.

4. The ISDA 2020 IBOR Fallback added a credit spread adjustment to SOFR for legacy LIBOR contracts — five-year median of the historical LIBOR–SOFR spread. For 3M USD LIBOR this adjustment was 26.161bps.

5. Swap conventions changed: SOFR swaps typically compound daily and pay annually with modified following business day conventions.

6. Hedging: firms rebalanced DV01 exposures as LIBOR curves were retired. Basis swaps (LIBOR vs SOFR) traded actively through 2023.

On the CFA exam, expect questions about: why SOFR is preferred (less manipulable, observable), the backward-looking issue, and calculation of compounded SOFR coupon payments given daily rates.

How has the SOFR transition from LIBOR changed swap pricing?

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