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Rf—The Most Important Number in the World | Part 1 : What exactly is Rf?!

Rf—The Most Important Number in the World | Part 1 : What exactly is Rf?!
AUTHOR: CA Anurag Sharma | 13th July 2021 | Read Time: 5-7 mins

It’s been quite some while since I wrote something….well, thanks to the ever-busy lifestyle that we build for ourselves (ironically, that too after years of hard work!!) & infact pride upon!

Today I would like to throw some light on the infamous Rf………RISK FREE RATE—–a term each of us have been hearing & using since time immemorial, but for most of us—it’s just a number that’s always provided in the book/question!

Ever wondered what exactly is the Rf and how is it determined?

——–

Hi guys…this is Anurag Sharma…qualified CA, CFA charterholder, a working professional with 6 years of corporate experience working across MNCs, and have recently ventured into teaching (at SSEI)–a passion I’ve wished to pursue for quite some time now. Also–before I delve deeper into the topic…I’d like to thank you all for your insightful comments on my previous articles!

——–

Background of Rf:

To put in lay man terms: Risk free rate is the rate which we expect to earn on our investment for deferring our consumption, excluding the inflation & risk factor involved in the investment.

The same risk free rate is also used for valuation of different financial instrument directly or indirectly be it equities, credit etc.

The obvious question is– How is the Rf calculated?

There are different ways of calculating Rf—-however one which is most popular & most widely used is (or rather ‘was’) LIBORLondon InterBank Offered Rate.

LIBOR is the rate published by Intercontinental Exchange [ICE] for different maturities ranging from overnight [1 day] to 12 months, in total seven tenors and in five different currencies [USD, GBP, EUR, CHF & JPY]

These rates are basically the average of rates submitted by different Global Banks for different maturities. It represents the rate at which Global banks are ready to lend money to each other in international markets.

Given it was derived from submission made by these Consortium of Global Banks for lending to each other, it was widely recognized as the risk free rate as it it is difficult to imagine that these banks would default ever.

And for this very reason….for the last 30 years, LIBOR has been used by all financial participants as RF. This has been used in valuation of almost all financial instruments– be it Equities, Derivatives, Bonds, Borrowing or Currency.

Infact, LIBOR has been used to such an extent [$200 trillion worth of contracts] that it has been named as the WORLD’s MOST IMPORTANT NUMBER!

Current & Future Scenario:

However, things took a turn in the aftermath of the 2008 Global Financial Crisis. Following months of investigation & extensive digging by Regulators, it was discovered that the so called Big Banks were actually manipulating the numbers to their advantage.

And finally in 2017, Financial Conduct Authority [FCA] UK declared that they would no longer be asking banks to submit their rates for calculation of LIBOR come 2021—which means that LIBOR rates would not be available after 2021 [except for few tenors i.e. overnight & 12-month US LIBOR which will be able till 2023]

FCA has also suggested market participants to transition to an alternative risk free rate [Rf]. In response, the Regulators & different market participants are developing a new benchmark rate which will replace LIBOR.

The next obvious question is: How is the new Rf different from LIBOR?

Well, while the LIBOR was completely based on the judgement of Consortium banks, the new Rf will actually be based on real life transactions. LIBOR was a forward-looking rate set in advance for different tenors. The new Rf is backward looking as it will be published based on transactions that have already taken place in the market.

We have two Rf coming for two major currency: USD & Sterling –named as Secured Overnight Financing Rate [SOFR] and Sterling OverNight Interbank Average rate [SONIA].

These rates are based on overnight transactions in REPO markets [simply put, where banks borrow from each other for overnight transactions]

In Indian context, RBI too has nudged the Indian banks to prepare for transition from MIBOR [Mumbai Interbank Offer Rate], which was based on LIBOR.

However, a transition as HUGE as this impacts all functions ranging from Risk Management to Operation, Valuation to Reporting, & so much more at a global level & scale.

This is just the trailer– as the famous dialogue goes— picture abhi baki hai mere dost!

There are so many questions….so many angles unanswered, so much to consolidate & understand & unravel:

—Some, only time can provide answer to.

—Others, I will try to update you via upcoming parts on this amazing platform of QForum Blogs!

Do let me know your thoughts in the comments section.

 
Happy Reading!

CA Anurag Sharma

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