Using Overnight Rates for Global Intercompany Loans

Introduction

As financial markets worldwide shift from traditional term rates to more robust benchmarks, it's crucial for corporates to adopt appropriate rates for their intercompany loans. While SOFR (Secured Overnight Financing Rate) in USD is widely recognized, other regions employ their own benchmarks, such as SORA in SGD, SONIA in GBP, and EURIBOR in EUR.

Compliance and Strategic Planning

Selecting a suitable rate ensures arm's length transactions between subsidiaries, maintaining compliance with international tax laws and transfer pricing regulations. This is vital to avoid potential tax penalties and ensure proper profit allocation and taxation across jurisdictions. Additionally, the right rate supports accurate financial forecasting and budgeting, crucial for long-term financial planning and operational stability.

Market Volatility and Rate Options

Overnight rates are inherently volatile as they reflect daily market conditions, including target cash rates. To assist in long-term financial planning, global financial bodies and ISDA have introduced several options:

• Daily Simple Rate: Calculated as a daily average, adjusted for non-working days. This simpler approach does not involve compounding, allowing corporates to manage payment timings through rate lags or payment delays.
• Average Rate in Arrears: This rate reinvests interest accrued daily, closely tracking market changes. It's widely used in derivatives and business loans, with the “shift” convention becoming more popular than “look back” for determining the compounded rate.
• Average Rate in Advance: Known at the start of the period, this rate uses a compounded average of the prior period for precise budgeting, although it may not reflect the current rate environment accurately.
• Term Rate: Less common in some regions, these rates are forward-looking, set based on futures and derivatives. For example, CME Term SOFR provides a predetermined rate for a set period.

Recommendations and Strategic Integration

Both Average Rate in Advance and Term Rate offer upfront knowledge of interest costs and are becoming more prevalent as benchmarks for intercompany loans. The ARRC (Alternative Reference Rates Committee) recommends:

• Using 30-day or 90-day average rates set in advance for various reset periods to integrate seamlessly into existing systems.
• Ensuring flexibility for multi-currency loans, enhancing their utility for multinational corporations.
• Being cautious of potential basis mismatches when hedging with average rates in advance, as most hedging instruments are based on average rates in arrears.

Conclusion

While the transition to new benchmarks may seem daunting, adopting an advanced analytic and management solution can align corporate financial strategies with regulatory requirements effectively.