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Dynamic term structure models for SOFR futures

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  • Jacob Bjerre Skov
  • David Skovmand

Abstract

The London InterBank Offered Rate is scheduled for discontinuation, and the replacement advocated by US regulators is the Secured Overnight Financing Rate (SOFR). The only SOFR‐linked derivative with significant liquidity and trading history is the SOFR futures contract, traded at the Chicago Mercantile Exchange. We use the historical record of futures prices to construct dynamic arbitrage‐free models for the SOFR term structure. We find that a Gaussian arbitrage‐free Nelson–Siegel model describes term structure well without accounting for jumps and seasonal effects observed in SOFR. However, a shadow‐rate extension is needed to describe volatility near the zero‐boundary impacting the futures convexity adjustment and option pricing.

Suggested Citation

  • Jacob Bjerre Skov & David Skovmand, 2021. "Dynamic term structure models for SOFR futures," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(10), pages 1520-1544, October.
    • Handle: RePEc:wly:jfutmk:v:41:y:2021:i:10:p:1520-1544
    DOI: 10.1002/fut.22246
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    References listed on IDEAS

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    7. Christensen, Jens H.E. & Diebold, Francis X. & Rudebusch, Glenn D., 2011. "The affine arbitrage-free class of Nelson-Siegel term structure models," Journal of Econometrics, Elsevier, vol. 164(1), pages 4-20, September.
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    9. Marcel A. Priebsch, 2013. "Computing arbitrage-free yields in multi-factor Gaussian shadow-rate term structure models," Finance and Economics Discussion Series 2013-63, Board of Governors of the Federal Reserve System (U.S.).
    10. Andrea Macrina & David Skovmand, 2020. "Rational Savings Account Models for Backward-Looking Interest Rate Benchmarks," Risks, MDPI, vol. 8(1), pages 1-18, March.
    11. Flesaker, Bjorn, 1993. "Testing the Heath-Jarrow-Morton/Ho-Lee Model of Interest Rate Contingent Claims Pricing," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(4), pages 483-495, December.
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    Cited by:

    1. David Skovmand & Jacob Bjerre Skov, 2022. "Decomposing LIBOR in Transition: Evidence from the Futures Markets," Papers 2201.06930, arXiv.org, revised Mar 2022.
    2. Backwell, Alex & Hayes, Joshua, 2022. "Expected and Unexpected Jumps in the Overnight Rate: Consistent Management of the Libor Transition," Journal of Banking & Finance, Elsevier, vol. 145(C).
    3. Marek Rutkowski & Matthew Bickersteth, 2021. "Pricing and Hedging of SOFR Derivatives under Differential Funding Costs and Collateralization," Papers 2112.14033, arXiv.org.
    4. Alessandro Gnoatto & Silvia Lavagnini, 2023. "Cross-Currency Heath-Jarrow-Morton Framework in the Multiple-Curve Setting," Papers 2312.13057, arXiv.org.
    5. Fred Espen Benth & Nils Detering & Luca Galimberti, 2022. "Pricing options on flow forwards by neural networks in Hilbert space," Papers 2202.11606, arXiv.org.
    6. Claudio Fontana & Zorana Grbac & Thorsten Schmidt, 2022. "Term structure modelling with overnight rates beyond stochastic continuity," Papers 2202.00929, arXiv.org, revised Aug 2023.
    7. Claudio Fontana, 2022. "Caplet pricing in affine models for alternative risk-free rates," Papers 2202.09116, arXiv.org, revised Jan 2023.

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