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SOFR term structure dynamics—Discontinuous short rates and stochastic volatility forward rates

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  • Alan Brace
  • Karol Gellert
  • Erik Schlögl

Abstract

The Secured Overnight Funding Rate (SOFR) has become the risk‐free rate benchmark in US dollars, thus term structure models should reflect key features exhibited by SOFR and forward rates implied by SOFR futures. We construct a multifactor, stochastic volatility term structure model which incorporates these features. Calibrating to options on SOFR futures, we achieve a reasonable fit to the market across maturities and strikes in a single model. This also provides novel insights into SOFR term rate behavior (and implied volatilities) within their accrual periods, and a model mechanism by which interest rate mean reversion arises from monetary policy.

Suggested Citation

  • Alan Brace & Karol Gellert & Erik Schlögl, 2024. "SOFR term structure dynamics—Discontinuous short rates and stochastic volatility forward rates," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 44(6), pages 936-985, June.
    • Handle: RePEc:wly:jfutmk:v:44:y:2024:i:6:p:936-985
    DOI: 10.1002/fut.22499
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    References listed on IDEAS

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