Compounded rate out of favour: what now? (2)

A recent blog of mine was titled "Compounded rate out of favour: what now?"

In this post, I try to answer my own question by proposing some solution for the loan market. I believe it can accommodate both sides of the issue: having interest rate based on overnight compounding in arrears and at the same time fixed amounts known at the start of the period.

Suppose that you had previously a one year loan with floating rate based on LIBOR-3M with payment of interest every 3 months and potential repayment of part of the notional after each of the 3 months periods.

What does the bank want: overnight based market risk. What does the bank accept: loan term credit risk on the end user for the stated notional. What does the end user want: floating rate with amounts paid at the end of each 3-month period known at the beginning of the period.

Those requirements may appear contradictory but they are not as described here. At the start of the first period, a temporary fixed rate is set for the next 3 months; the amount paid at the end of the period is based on that rate. At the end of the first period, the user pays the agreed fixed rate (fixed amount known at the start of the period). The overnight compounding in arrears implied rate is computed. The difference between the compounded rate and the fixed rate is added to the loan notional. The client repays any notional he wants to repay. For the second period another fixed rate is agreed and the amount to be paid at the end of the second period is based on the fixed interest on the adjusted notional (original notional + rate adjustment - notional reimbursed). Again the notional is adjusted to take into account the difference in rate between compounded and fixed. The same procedure apply to all 3-month periods. We come to the end of the last period, where there will perhaps be some residual interest to pay (or reimburse). Here and only here we use the 5 day delay now traditional in bonds. The user (or the bank, depending of the adjustment) has to pay the residual spread at the end of a 5-(business)-day period. Obviously some interest has to be paid on that amount, it can be done at a lockout rate. Note that the interest to be paid in this lockout mechanism is the interest on the spread between some forward-looking rate and a backward looking rate. This is not interest on a notional, this is not interest on interest, this is interest on a spread of interests.

From a market risk perspective, if we ignore the small risk related to the 5-day lockout period, the risk is the same as the risk on an overnight composition (without shift of delay). This is a cleaner risk that the one proposed in ISDA fallback or in other similar mechanisms. The only item not certain in advance is the notional. It is not known in advance, but it is always known at the start of the day for which the rate applies. No hidden option or convexity there. The is a small market risk over a 5-day period on the interest spread. The credit risk is on the notional, with maybe some small increase of the order of magnitude of 10 basis points over one 3-month period.

From the client perspective, he has the clarity of the amount to be paid 3 months in advance (except the last small adjustment where there is a 5 day notice), the interest can be accrued like a fixed rate over that 3-month period.

Some details need to be agreed. What type of fixed rate will be used as forward looking rate. I would suggest the official central bank target rate. This remove any possibility of manipulation. Remember that the rate is only provisional, so even if the rate is 25 or 50 basis point away from the actual composition, the adjustment at the end of the period is of the order of magnitude of 6.25 to 12.5 basis points. The amount is not lost or gained, but its payment is postponed and interest is paid on the postponement. The 5-day lockout period is probably acceptable. One ISDA proposal on derivative fallback was to have a lockout of the interest applied to the full notional; our proposal is a lockout on a interest spread.

Some extra conditions may need to be set to insure that the loan notional does not increase too much. Maybe the notional adjustment, if it increase the notional will need to be repaid at the next reset date. Some accounting flexibility may be required from the borrower accountants. The fixed amount paid may be considered as actual accrual of the rate and the adjustment payments either as a fee or as an interest. Some flexibility may be required in such a way that the user has not to develop a full overnight composition accounting system. Regulators need to offer the flexibility to the user to use those mechanism without accusing them to hide their borrowing costs.

Obviously the question of the credit risk spread has to be discussed. Where are the spreads applied, are they on overnight rates and compounded, are they on the simple rate for each period, etc. You can contact me directly for discussion on those issue. I can not provide all my secret sauces recipes in my blogs ;)

Hopefully this proposal will help to reconcile compounded in arrears and term rate in the loan market.

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