Banking across borders: At the crossroads in the transition away from LIBOR - from overnight to term rates

This note evaluates ways of how new loans can be based on risk-free overnight (O/N) rates, the chosen successors to LIBOR (e.g. SOFR in the US). So far, O/N rates have not been widely adopted in the loan market, as this market is used to know the term rate at the beginning of an interest period. The loan market would prefer to replace LIBOR with another forward-looking term rate, i.e. a term rate that is known at the beginning and reflects expectation. However, these term rates currently do not exist and have several disadvantages. Instead of a forward-looking term rate one can also use past realizations of O/N rates to define a term rate at the beginning of an interest rate period. A common objection by using past realizations of O/N rates is that this introduces a lagged behavior (or 'basis'), which can be especially severe in periods when policy rates change rapidly. In this note, we evaluate the basis and show ways how to minimize it. We conclude that the ideal option to reduce the basis is to use a shortened observation period when computing term rates based on past O/N rate realizations.