TERM STRUCTURE MODELING OF SOFR: EVALUATING THE IMPORTANCE OF SCHEDULED JUMPS

Erik Schlã–gl, Jacob Bjerre Skov and David Skovmand ()
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Erik Schlã–gl: School of Mathematical and Physical Sciences, University of Technology Sydney, Ultimo 2007, NSW, Australia2The African Institute of Financial Markets and Risk Management (AIFMRM), University of Cape Town, Cape Town 7701, South Africa3Faculty of Science, Department of Statistics, University of Johannesburg, Johannesburg 2006, South Africa
Jacob Bjerre Skov: Department of Mathematical Sciences, University of Copenhagen, 2100 Copenhagen, Denmark
David Skovmand: Department of Mathematical Sciences, University of Copenhagen, 2100 Copenhagen, Denmark

International Journal of Theoretical and Applied Finance (IJTAF), 2024, vol. 27, issue 02, 1-34

Abstract: As interest rate benchmarks move from LIBOR to overnight risk-free rates (RFR), it has become increasingly important for models to accurately capture the interest rate dynamics at the overnight tenor. Overnight rates closely track central bank policy rate decisions resulting, in highly discontinuous dynamics around scheduled meeting dates. In this paper, we construct a dynamic term structure model, which accounts for the discontinuous short-rate dynamics. We show that the model is able to jointly fit the overnight US policy rate, secured overnight financing rate (SOFR) and SOFR futures rates through the recent Fed hiking cycle. Comparing our model with a standard continuous time-homogeneous short-rate model, we find several indications that our model avoids the clear misspecification of the continuous model, in particular with regard to the short-rate dynamics around meeting dates of the Federal Open Market Committee (FOMC). Thiseffect begins to disappear as the term of the rates under consideration is increased, suggesting that diffusive dynamics are a reasonably accurate reflection of the evolution of market expectations embodied in longer-term interest rates.

Keywords: SOFR; jumps; FOMC; futures (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1142/S0219024924500092

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