 Expected and Unexpected Jumps in the Overnight Rate: Consistent Management of the Libor TransitionAlex Backwell and Joshua Hayes Journal of Banking & Finance, 2022, vol. 145, issue C Abstract: Interest-rate benchmark reform has revived short-rate modelling. One reason is that short-rate models provide a consistent framework in which different benchmarks, and contracts linked to them, can be compared. Another reason is that new benchmarks can be directly dependent on very short-term rates; the key example is a backward-looking compounding of overnight rates, a prominent alternative to forward-looking Libor. Indeed, under Libor, one can often safely ignore aspects of short-rate behaviour, especially jumps. At least partially for this reason, jumps are inadequately treated in the interest-rate literature, particularly expected jumps (jumps with known timing). We estimate a model with expected and unexpected jumps, which involves separating their effect on term rates. We then price forward- and backward-looking caplets, quantifying the spread exhibited by the latter over the former. Expected jumps lead to significantly time-inhomogeneous option behaviour, particularly for short-term options linked to a backward-looking benchmark. Keywords: Benchmark reform; Libor transition; interest-rate jumps; short-rate modelling; stochastic discontinuities; interest-rate options (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:145:y:2022:i:c:s0378426622002497 DOI: 10.1016/j.jbankfin.2022.106669 Access Statistics for this article Journal of Banking & Finance is currently edited by Ike Mathur More articles in Journal of Banking & Finance from Elsevier |
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