Rational Savings Account Models for Backward-Looking Interest Rate Benchmarks
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Rational Savings Account Models for Backward-Looking Interest Rate Benchmarks. / Macrina, Andrea; Skovmand, David.
In: Risks, Vol. 8, 23, 2020.Research output: Contribution to journal › Journal article › Research › peer-review
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TY - JOUR
T1 - Rational Savings Account Models for Backward-Looking Interest Rate Benchmarks
AU - Macrina, Andrea
AU - Skovmand, David
PY - 2020
Y1 - 2020
N2 - Interest rate benchmarks are currently undergoing a major transition. The LIBOR benchmark is planned to be discontinued by the end of 2021 and `replaced' by what ISDA calls an adjusted risk-free rate (RFR). ISDA has recently announced that the LIBOR `replacement' will most likely be constructed from a compounded running average of RFR overnight rates over a period matching the LIBOR tenor. This new backward-looking benchmark is markedly different when compared with LIBOR. It is measurable only at the end of the term in contrast to the forward-looking LIBOR, which is measurable at the start of the term. On the other hand though, RFRs provide a simplification because the cash flows and the discount factors may be derived from the same discounting curve, thus avoiding--on a superficial level--any multi-curve complications. We develop a new class of savings account models and derive a novel interest rate system specifically designed to facilitate a high degree of tractability for the pricing of RFR-based fixed-income instruments. The rational form of the savings account models under the risk-neutral measure enables the pricing in closed form of caplets, swaptions and futures written on the backward-looking interest rate benchmark. An interesting twist is that the proposed rational savings account models are different from so-called short rate models in that they cannot necessarily be expressed as an exponentiated integral of a short rate of interest.
AB - Interest rate benchmarks are currently undergoing a major transition. The LIBOR benchmark is planned to be discontinued by the end of 2021 and `replaced' by what ISDA calls an adjusted risk-free rate (RFR). ISDA has recently announced that the LIBOR `replacement' will most likely be constructed from a compounded running average of RFR overnight rates over a period matching the LIBOR tenor. This new backward-looking benchmark is markedly different when compared with LIBOR. It is measurable only at the end of the term in contrast to the forward-looking LIBOR, which is measurable at the start of the term. On the other hand though, RFRs provide a simplification because the cash flows and the discount factors may be derived from the same discounting curve, thus avoiding--on a superficial level--any multi-curve complications. We develop a new class of savings account models and derive a novel interest rate system specifically designed to facilitate a high degree of tractability for the pricing of RFR-based fixed-income instruments. The rational form of the savings account models under the risk-neutral measure enables the pricing in closed form of caplets, swaptions and futures written on the backward-looking interest rate benchmark. An interesting twist is that the proposed rational savings account models are different from so-called short rate models in that they cannot necessarily be expressed as an exponentiated integral of a short rate of interest.
KW - LIBOR
KW - SOFR
KW - SONIA
KW - Rational Term Structure Models
KW - Swaptions
KW - Caplets
KW - Futures.
U2 - 10.3390/risks8010023
DO - 10.3390/risks8010023
M3 - Journal article
VL - 8
JO - Risks
JF - Risks
SN - 2227-9091
M1 - 23
ER -
ID: 250123611