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Optimal Pricing and Hedging of SOFR Derivatives

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  • Teemu Pennanen
  • Waleed Taoum

Abstract

Thousands of SOFR derivatives are available in exchanges and OTC, but the market remains illiquid and incomplete. Such a market is beyond the scope of classic risk-neutral approaches that imply linear pricing rules and, at best, approximate hedging strategies whose hedging error may be difficult to quantify. This paper develops an indifference pricing model which is consistent with observed derivative quotes, the agent's financial position and views about the uncertain future as well as risk preferences as described by a convex risk measure. In addition to prices and hedging strategies, the model gives an explicit description of the hedging error and the associated risk. The approach is illustrated numerically using hundreds of CME-listed derivatives to price and hedge unreplicable OTC SOFR derivatives. The indifference prices are computed in less than a minute on a regular PC. We find that the optimal hedging portfolios tend to be sparse but still provide good approximations of the derivative payouts.

Suggested Citation

  • Teemu Pennanen & Waleed Taoum, 2026. "Optimal Pricing and Hedging of SOFR Derivatives," Papers 2608.10711, arXiv.org.
    • Handle: RePEc:arx:papers:2608.10711
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    References listed on IDEAS

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    1. Teemu Pennanen & Waleed Taoum, 2025. "Statistical Modeling of SOFR Term Structure," Applied Mathematical Finance, Taylor & Francis Journals, vol. 32(4), pages 253-288, July.
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    3. Erik Schlã–Gl & Jacob Bjerre Skov & David Skovmand, 2024. "Term Structure Modeling Of Sofr: Evaluating The Importance Of Scheduled Jumps," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 27(02), pages 1-34, March.
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    6. Teemu Pennanen, 2014. "Optimal investment and contingent claim valuation in illiquid markets," Finance and Stochastics, Springer, vol. 18(4), pages 733-754, October.
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    9. John Armstrong & Teemu Pennanen & Udomsak Rakwongwan, 2018. "Pricing index options by static hedging under finite liquidity," Papers 1803.02486, arXiv.org.
    10. Fengming Liu & Yingda Song, 2024. "Risk-free rate caplets pricing by CTMC approximation," Quantitative Finance, Taylor & Francis Journals, vol. 24(11), pages 1579-1595, November.
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    12. Teemu Pennanen & Luciane Sbaraini Bonatto, 2026. "An integrated optimisation model for pricing and hedging oil derivatives," Review of Derivatives Research, Springer, vol. 29(1), pages 1-33, December.
    13. John Armstrong & Teemu Pennanen & Udomsak Rakwongwan, 2018. "Pricing Index Options By Static Hedging Under Finite Liquidity," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(06), pages 1-18, September.
    14. Damiano Brigo & Marco Francischello & Andrea Pallavicini, 2017. "An indifference approach to the cost of capital constraints: KVA and beyond," Papers 1708.05319, arXiv.org.
    15. Andrey Itkin & Yerkin Kitapbayev, 2024. "Semi-analytical pricing of options written on SOFR futures," Papers 2409.04903, arXiv.org, revised Oct 2024.
    16. Teemu Pennanen, 2011. "Arbitrage and deflators in illiquid markets," Finance and Stochastics, Springer, vol. 15(1), pages 57-83, January.
    17. Andrea Macrina & David Skovmand, 2020. "Rational Savings Account Models for Backward-Looking Interest Rate Benchmarks," Risks, MDPI, vol. 8(1), pages 1-18, March.
    18. Teemu Pennanen & Luciane Sbaraini Bonatto, 2026. "Correction: An integrated optimisation model for pricing and hedging oil derivatives," Review of Derivatives Research, Springer, vol. 29(1), pages 1-1, December.
    19. Charles R. Harris & K. Jarrod Millman & Stéfan J. Walt & Ralf Gommers & Pauli Virtanen & David Cournapeau & Eric Wieser & Julian Taylor & Sebastian Berg & Nathaniel J. Smith & Robert Kern & Matti Picu, 2020. "Array programming with NumPy," Nature, Nature, vol. 585(7825), pages 357-362, September.
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