Pricing interest rate derivatives under monetary changes

Alan De Genaro; Marco Avellaneda

doi:10.1142/S0219024918500371

Pricing interest rate derivatives under monetary changes

Alan De Genaro, Marco Avellaneda

Mathematics

Research output: Contribution to journal › Article › peer-review

Abstract

The goal of this paper is to develop a reduced-form model for pricing derivatives on the overnight rate. The model incorporates jumps around central bank (CB) meetings. More specifically, rate changes are decomposed into fluctuations between CB meetings and deterministic timed jumps following CB meetings. This approach is useful for practitioners, since it allows the extraction of expectations regarding central bank decisions embedded in liquid instruments, as well as the use of these expectations for the pricing of less liquid derivatives, such as options, in a consistent manner. We discuss applications to 30-Day Fed funds options and IDI options traded in Brazil.

Original language	English (US)
Article number	1850037
Journal	International Journal of Theoretical and Applied Finance
Volume	21
Issue number	6
DOIs	https://doi.org/10.1142/S0219024918500371
State	Published - Sep 1 2018

Keywords

Overnight interest rate
deterministic timed jumps
interest rate derivatives

ASJC Scopus subject areas

Finance
Economics, Econometrics and Finance(all)

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10.1142/S0219024918500371

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title = "Pricing interest rate derivatives under monetary changes",

abstract = "The goal of this paper is to develop a reduced-form model for pricing derivatives on the overnight rate. The model incorporates jumps around central bank (CB) meetings. More specifically, rate changes are decomposed into fluctuations between CB meetings and deterministic timed jumps following CB meetings. This approach is useful for practitioners, since it allows the extraction of expectations regarding central bank decisions embedded in liquid instruments, as well as the use of these expectations for the pricing of less liquid derivatives, such as options, in a consistent manner. We discuss applications to 30-Day Fed funds options and IDI options traded in Brazil.",

keywords = "Overnight interest rate, deterministic timed jumps, interest rate derivatives",

author = "{De Genaro}, Alan and Marco Avellaneda",

note = "Funding Information: we are indebted to numerous seminar participants at Morgan Stanley (NYC), XP Investments (Brazil), EAESP/FGV, IMPA for their comments. Alan De Genaro gratefully acknowledges the financial support of B3 and Courant Institute for its generous hospitality during the period that part of this research was conducted. Any remaining errors are our own. Publisher Copyright: {\textcopyright} 2018 World Scientific Publishing Company. Copyright: Copyright 2018 Elsevier B.V., All rights reserved.",

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