Understanding SOFR strips

One of the key reasons SOFR futures have become so liquid and successful is because of hedgers who use the market to hedge against adverse interest rate fluctuations.

• If someone is concerned about rising rates, they might sell SOFR futures.
  
• If someone is concerned about declining rates, they might buy SOFR futures.

Keep in mind that SOFR futures prices tend to move inversely with interest rates.

Many loans are structured such that the rate floats periodically (e.g. the interest rate is reset quarterly). This introduces a risk that rates may fluctuate before each loan reset date. SOFR futures can be used to address this possibility since they are listed on a quarterly basis extending approximately 10 years into the future. 

There are various strategies for hedging with SOFR futures that involve stacking and stripping futures contracts as well as products called packs and bundles, which are packaged strips. More information about packs and bundles can be found in the next lesson.

Assume that it is March 2024 and a corporation enters into a two-year bank loan repayable in March 2026 for $100 million. The loan rate is reset every three months using Term SOFR plus a fixed premium. This means that the corporation remains exposed to the risk that rates advance by each of the seven subsequent loan rate reset dates.

The floating rate loan can be decomposed into seven successively deferred 90-day loans. The BPV associated with each of those seven loans equals $2,500.

BPV = $100,000,000 x (90/360) x 0.01% = $2,500

The corporation might sell 100 SOFR futures in successive quarterly contract months to match the seven successive quarterly loan reset dates, effectively hedging each of the loan periods independently. This transaction is often referred to as a strip hedge, or a series of short (or long) SOFR futures in successively deferred contract months to hedge the risk of rising (or declining) rates. 

If rates climb higher over the term of the loan, the short SOFR futures contracts would be profitable, since the futures price tends to decline as rates rise. The profit on the strip of SOFR futures would offset the increased borrowing costs, effectively locking in a lower rate. 

Corporate treasurers and bank asset liability managers are particularly sensitive to fluctuations in interest rates since borrowing and lending rates directly influence profitability. SOFR strips (as well as packs and bundles) can help market participants hedge floating rate loans.