Risk Free Rates (RFRs)

RFRs vs LIBOR
- Source data
LIBOR: heavily based on expert judgement.
RFRs: actual transactions.
- Credit premium
LIBOR: embeds interbank credit spread (it is a representation of the funding cost that the
global bank would be able to borrow at arm’s length for a specific term).
RFRs: nearly risk free rates = generally lower than LIBOR, so should incorporate additional
adjustment that takes into account the interbank credit spread.
Credit adjustment spreads (CAS): the adjustment needed to equally LIBOR to RFRs
(‘LIBOR = RFR + CAS).
- Term
LIBOR: available over 7 tenors (overnight / 1 week / 1 month / 2 months / 3 months / 6
months / 12 months).
RFRs: most do not have term fixings; they are backward looking.
- Fixing
LIBOR: rates fixed at the beginning of the period and known in advance.
RFRs: rates fixed based on daily observation and known in arrears.
- Settlement
LIBOR: settlement value known from inception.
RFRs: settlement value known depending on convention employed (eg in advance / in arrears
/ lookout / lag or shift).

Interest accrual conventions

In arrears

• Base (plain): use the averaged RFR over current interest period, paid at end of period (not
popular).

• Payment delay: use the averaged RFR over current interest period, paid k days after the start
of the next period.

• Lockout: use a k day lockout for the rates before the period ends.

• Lookback (with or without observation shift): for every day in the current interest period, use
the RFR from k days earlier (usually 5 business days). Most prevalent convention.
In advance

• Last reset (period shift): use compounded RFR for a historical observation period equal to the
future interest period.

• Last recent (short period): use compounded RFR for a historical observation period shorter
than the future interest period.

These conventions aim to create some economic certainty for a number of days (since RFRs are
backward looking). Also for logistic issues (notice of payment).

Simple vs compound averaging

Simple interest: the additional amount of interest owed each day is calculated by applying the
daily rate of interest to the principal borrowed, and the payment due at the end of the period is
the sum of these amounts —> it does not take into account unpaid interest that needs to be
capitalised on the principal.

Compound interest (‘interest on interest’): the additional amount of interest owed each day is
calculated by the daily rate of interest both to the principal borrowed and the accumulated unpaid
interest —> recognises that the borrower does not pay back interest owed on a daily basis (ie
keeps track of the accumulated interest owed but not yet paid).

—> But under the current low interest rate environment, the difference between both approaches
is almost negligible.

Note: in some jurisdictions, applying interest on interest may be forbidden by law (eg Germany;
Italy; France, with slight nuance); and there can be national laws that make the application of
compound interest more complicated. However, there have been suggestions (including from the
LMA) that we should not think of compounded interest conventions as a means of applying
interest on interest, but as a different accrual methodology —> so it is possible that we could
apply compounded interest on those countries, but there is no caselaw.

Cumulative vs non cumulative compounding

Cumulative compounding: compounds the rate for the whole period —> therefore does not
deal well with intra period events (eg prepayment / mid period asset sales / RCF).

Non cumulative compounding: done overnight —> one potential solution to account for intra
period events. Downside: more complex to implement from a system perspective, and more
complex to document from a legal perspective.

Lookback without observation shift (lag) vs lookback with observation shift

(backward shift)
Note: for the vast majority of days, there is no difference; but there are some case where it does
make a difference (ie when there are public holidays).

Example: Calculate interest accrual on Monday 03 Jun (Mon 27 May public holiday), with 5 day
lookback.

In both approaches, you take the rate from 5 business days before (ie Friday 24 May).
Difference: the weight applied to Friday 24 May —>

• With observation shift (backward shift): (2.37 x 4) / 360 —> takes the rate from 5 business
days before (ie 2.37), and weights it according to the observation period (ie 4). Note: the
weight applied to Friday 24 May is 4 because there are 3 non business days following.

• Without observation shift (lag): (2.37 x 1) / 360 —> takes the rate from 5 business days
before (ie 2.37), but weights it according to the interest period (ie 1).
Source
https://www.youtube.com/watch?v=9pVSfl-R5Dk