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

Giacomo Burro (), Pier Giuseppe Giribone (), Simone Ligato (), Martina Mulas () and Francesca Querci
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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

International Journal of Financial Engineering (IJFE), 2017, vol. 04, issue 02n03, 1-27

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.

Keywords: Option pricing; negative interest rates; Black–Scholes framework; Bachelier model (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S2424786317500347

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