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Negative interest rates effects on option pricing: Back to basics?

Author

Listed:
  • Giacomo Burro

    (Department of Economics and Business Studies, University of Genova, Via Vivaldi 5, 16126 Genova, Italy)

  • Pier Giuseppe Giribone

    (Financial Administration-Engineering and Pricing, Carige Banking Group, via Cassa di Risparmio 15, 16123 Genova, Italy)

  • Simone Ligato

    (Risk Management, Azzoaglio Private Bank, via A. Doria 17, 12073 Ceva (CN), Italy)

  • Martina Mulas

    (KPMG Advisory, via Vittor Pisani, 20124 Milan, Italy)

  • Francesca Querci

    (Department of Economics and Business Studies, University of Genova, Via Vivaldi 5, 16126 Genova, Italy)

Abstract

We provide the first formal investigation of the consequences of negative interest rates in the Eurozone on the pricing of interest rate options. Since the money market rates settled in negative territory and other market segments experienced negative yields, the broader financial community has had to face an unknown environment. The well-known Black–Scholes (BS) framework has become unfeasible for interest rate option valuation. First of all, no-arbitrage properties are breached, allowing arbitrage opportunities. More, the BS framework’s assumption of a log-normal distribution of the underlying rates does not stand with negative interest rates. We argue that the most notable approach which allows interest rate option pricing is [Bachelier, L (1900). Théorie de la speculation, 3rd Annales scientifiques de l’École Normale Supēérieure 17, 21–86.], which assumes a normal distribution of the underlying rates. We demonstrate that the Bachelier model represents an answer to the critical issues that are raised in our study. Still, we highlight that it is far from being an accurate pricing model. Our research aims to light up an intense debate about alternative solutions among academics, financial professionals and institutions, and policy makers.

Suggested Citation

  • Giacomo Burro & Pier Giuseppe Giribone & Simone Ligato & Martina Mulas & Francesca Querci, 2017. "Negative interest rates effects on option pricing: Back to basics?," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 4(02n03), pages 1-27, June.
    • Handle: RePEc:wsi:ijfexx:v:04:y:2017:i:02n03:n:s2424786317500347
    DOI: 10.1142/S2424786317500347
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    References listed on IDEAS

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    1. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    2. Patrick Hagan & Diana Woodward, 1999. "Equivalent Black volatilities," Applied Mathematical Finance, Taylor & Francis Journals, vol. 6(3), pages 147-157.
    3. Miltersen, Kristian R & Sandmann, Klaus & Sondermann, Dieter, 1997. "Closed Form Solutions for Term Structure Derivatives with Log-Normal Interest Rates," Journal of Finance, American Finance Association, vol. 52(1), pages 409-430, March.
    4. Michael R. Asay, 1982. "A note on the design of commodity option contracts," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 2(1), pages 1-7, March.
    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    6. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 231-237, December.
    7. A. James Boness, 1964. "Elements of a Theory of Stock-Option Value," Journal of Political Economy, University of Chicago Press, vol. 72(2), pages 163-163.
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    Cited by:

    1. Pier Giuseppe Giribone & Simone Ligato & Francesco Penone, 2018. "Combining robust dynamic neural networks with traditional technical indicators for generating mechanic trading signals," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 5(04), pages 1-44, December.

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