Exploring options on One-Month SOFR futures

Exhibit 1 summarizes the contract specifications. In general, the option contract features closely mimic the CME’s extant suite of Fed Funds options. A noteworthy difference is the number of expiries: four SR1 compared to 24 Fed Funds expiries.

Exhibit 1
Contract specifications for options on One-Month SOFR futures
(All times of day are Chicago time.)

Termination of trading in any expiring option is scheduled to occur at close of trading on the last business day of the contract month.

Each option is exercisable into a specified CME One-Month SOFR futures (“futures”) contract. 

SR1 options offer exercise prices in increments of 6.25 basis points (0.0625 IMM Index point) and 12.5 basis points (0.125 IMM Index point).

The exercise prices for the 6.25 basis point increments will be listed daily 10 exercise prices above and below the nearest-to-the-money exercise price. For example, assume the prior day’s activity produced a nearest-to-the-money exercise price of 95.00. The 6.25 basis point increments would have produced a highest exercise price of 95.625 and the following exercise prices that are 25 basis points (0.25 IMM Index point) above the nearest-to-the-money: 95.0625, 95.125, 95.1875, 95.25. The 6.25 basis point increments would have produced a lowest exercise price of 94.3750 and the following exercise prices that are 25 basis points (0.25 IMM Index point) below the nearest-to-the-money: 94.9375, 94.8750, 94.8125, 94.75.  

The exercise prices for the 12.5 basis point increments will be listed daily five exercise prices above and below the nearest 6.25 basis point increment. For example, assume the prior day’s activity produced a nearest-to-the-money exercise price of 95.00. The 12.5 basis point increments would have produced the following exercise prices that are above the highest 6.25 basis point increment: 95.75, 95.875, 96.00, 96.125, 96.25. The 12.5 basis point increments would have produced the following exercise prices that are below the lowest 6.25 basis point increment: 94.25, 94.125, 94.00, 93.875, 93.75.  

For users of Fed Funds options, the pricing of SR1 options is familiar. They are based on 100 basis points (1.00 IMM Index point) representing $4,167 per contract. Equally, 0.01 IMM index point represents $41.67 per contract. Generally, with a few exceptions, the smallest price increment for SR1 options is a ¼ basis point (0.0025 IMM index point) equal to $10.4175 per contract.

SR1 options utilize the American-style option exercise. Therefore, the option buyer has the right to exercise the option on any day they are traded.

Traders should be mindful of potential differences in SOFR and Fed Funds volatilities as they are developing option pricing models. Based upon One-Month SOFR and Fed Funds futures price data from May 2018 through Dec. 10, 2020, the rolling front serial contract months produced the following 20-day historical volatilities (annualized) and correlation of daily price changes:

Exhibit 2
One-Month SOFR and Fed Funds futures, 20-day historical volatility and correlation

Rolling front serial contract month
Data source: CME Group

The high correlation and similar volatilities demonstrate Fed Funds (FF) futures and options are an appropriate hedge for One-Month SOFR (SR1) futures and options. Nevertheless, the difference in the chart of the implied yields shows the complementary nature of these products since the launch of SOFR futures in May 2018. The underlying effective federal funds and repo markets clearly have factors that may drive one and not the other. Please refer to Exhibit 3 below for the history of implied yields for FF and SR1 futures prices since May 2018.

Exhibit 3
One-Month SOFR and Fed Funds futures
Implied yields of the nearby contract, May 2018-Dec. 10, 2020

Suppose you are concerned that year-end balance sheet pressures will lead to higher repo rates and lower SOFR futures prices. In 2018, overnight SOFR rose more than 50 basis points at year-end, from 2.46% to 3% on Dec. 31.

On Dec. 11, 2020, the Dec 2020 One-Month SOFR (SR1Z0) futures settled at 99.9275 (0.0725%), nearly identical to the latest SOFR print of 0.08% for Dec. 11. If similar circumstances occur, overnight SOFR would rise to 0.58%, projecting a final settlement price of 99.903 (0.097%) for SR1Z0 futures.

On Dec. 14, SR1Z0 99.9375 puts had a prior day settlement price of 2.5 basis points ($104.18 = ((0.025 X 100) X $41.67), giving them an implied volatility of 46.4% with 17 days to trade. Assuming a final futures settlement price of 99.903, the 99.9375 puts would have intrinsic value of 3.45 basis points ($143.76 = (0.0345 X 100) X $41.67) at expiration. Combining these puts with short positions in lower strike puts should produce more favorable outcomes.

One-Month SOFR options are an ideal complement to manage front end funding risk and volatility exposures. Trade them outright or against the similarly construction Federal Funds futures. With continued monetary and fiscal policy providing unique risk to the front-end of the curve, One-Month SOFR options further complement the range of risk management tools available to manage interest rate volatility.