Interest rate swaps: a comparison of compounded daily versus discrete reference rates

The article delves into the comparison of compounded daily versus discrete reference rates for interest rate swaps, with a particular focus on their effectiveness in hedging floating rate loans. Prior to the 2007 credit crisis, interest rate derivatives were based on LIBOR, which was later found to be manipulated. This led to the introduction of SOFR as an alternative reference rate. The paper explores the challenges and implications of using SOFR, which is based on an overnight rate and compounded daily, for hedging purposes. It highlights that while LIBOR-based swaps provide a static hedge, SOFR-based swaps do not, due to the differences in their maturity structures. The study concludes that daily SOFR is a poor choice for reference rates, as it destroys the possibility of an exact static hedge for floating rate loans. The analysis is conducted in the context of a frictionless, competitive, and arbitrage-free bond market model, providing a robust framework for understanding the implications of these reference rates.