IDEAS home Printed from https://ideas.repec.org/a/taf/quantf/v24y2024i8p1017-1033.html
   My bibliography  Save this article

Spike and hike modeling for interest rate derivatives: with an application to SOFR caplets

Author

Listed:
  • Leif Andersen
  • Dominique Bang

Abstract

After the replacement of Libor with alternative reference rates across the world, market participants must now adjust to a variety of changes to both contract terms and market rate dynamics. Focusing mostly on the new SOFR rate in the US, this paper considers the interaction of two important characteristics of SOFR derivatives: the backward-looking settlement style of SOFR floating rate payments; and the historically ‘jagged’ nature of SOFR time series. We introduce mechanisms that allow us to modify existing term structure models to incorporate rich dynamics for both ‘surprising’ and anticipated spikes and hikes in overnight rates. Numerical tests on SOFR-style caplets show that such model enhancements can produce significant effects on implied caplet volatility levels and skews. Besides establishing a practitioner-friendly framework for derivatives pricing, our paper is broadly applicable to scenario generation and risk management in any market with discontinuous rates dynamics.

Suggested Citation

  • Leif Andersen & Dominique Bang, 2024. "Spike and hike modeling for interest rate derivatives: with an application to SOFR caplets," Quantitative Finance, Taylor & Francis Journals, vol. 24(8), pages 1017-1033, August.
    • Handle: RePEc:taf:quantf:v:24:y:2024:i:8:p:1017-1033
    DOI: 10.1080/14697688.2024.2364800
    as

    Download full text from publisher

    File URL: http://hdl.handle.net/10.1080/14697688.2024.2364800
    Download Restriction: Access to full text is restricted to subscribers.
    File URL: https://libkey.io/10.1080/14697688.2024.2364800?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:taf:quantf:v:24:y:2024:i:8:p:1017-1033. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no bibliographic references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Chris Longhurst (email available below). General contact details of provider: http://www.tandfonline.com/RQUF20 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.