IBOR (interbank offer rates for e.g. LIBOR) cessation requires the transition to alternative reference rates (ARRs), and consideration of the differences in the nature of ARRs compared to IBORs. This move away from IBOR will change the pricing, valuation, and risk management practices, notably in the financial services sector but also for any entity that uses financial instruments.
IBOR transition is an ongoing, continuous and rapidly evolving process and not some future “big bang” event. It has already impacted valuations today (for example: CCP changes to Price Alignment Interest Cleared derivative valuations, albeit with a centralized compensation mechanism).
While there are many complexities around the transition, valuation challenges that the industry will need to navigate are interrelated and can be grouped under three broad headings:
- Valuation impact of terms in existing IBOR inventory - which will survive IBOR cessation and will require consideration of the applicable “fallback” methodology and any potential compensation mechanism;
- Valuation impacts of evolving market liquidity – in new products utilizing the ARRs as the market develops, as well as ongoing impacts on existing exposures;
- Valuation impacts of new risks – including basis risks, tail risks and model risk as portfolios combine IBOR and non-IBOR indexed risks.
The aim of this Perspectives Paper is to outline the key challenges that arise for valuation professionals from the cessation of IBOR. It outlines the changes in Governance, Data Management and Model Risk Management that entities need to consider to effectively manage the transition. The paper also outlines the areas that can contribute to ‘Valuation Uncertainty’ and thereby increase Valuation Risk in valuations of financial instruments arising from the cessation of IBOR.