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Open AccessFeature PaperArticle

Rational Savings Account Models for Backward-Looking Interest Rate Benchmarks

1
Department of Mathematics, University College London, London WC1E 6BT, UK
2
African Institute for Financial Markets and Risk Management, University of Cape Town, Rondebosch 7701, South Africa
3
Department of Mathematics, University of Copenhagen, 2100 Copenhagen, Denmark
*
Author to whom correspondence should be addressed.
Risks 2020, 8(1), 23; https://doi.org/10.3390/risks8010023
Received: 20 January 2020 / Revised: 21 February 2020 / Accepted: 24 February 2020 / Published: 3 March 2020
(This article belongs to the Special Issue Interest Rate Risk Modelling in Transformation)
Interest rate benchmarks are currently undergoing a major transition. The LIBOR benchmark is planned to be discontinued by the end of 2021 and superseded by what ISDA calls an adjusted risk-free rate (RFR). ISDA has recently announced that the LIBOR replacement will most likely be constructed from a compounded running average of RFR overnight rates over a period matching the LIBOR tenor. This new backward-looking benchmark is markedly different when compared with LIBOR. It is measurable only at the end of the term in contrast to the forward-looking LIBOR, which is measurable at the start of the term. The RFR provides a simplification because the cash flows and the discount factors may be derived from the same discounting curve, thus avoiding—on a superficial level—any multi-curve complications. We develop a new class of savings account models and derive a novel interest rate system specifically designed to facilitate a high degree of tractability for the pricing of RFR-based fixed-income instruments. The rational form of the savings account models under the risk-neutral measure enables the pricing in closed form of caplets, swaptions and futures written on the backward-looking interest rate benchmark. View Full-Text
Keywords: LIBOR; SOFR; SONIA; LIBOR transition; risk-free rates; rational term structure models; swaptions; caplets; futures LIBOR; SOFR; SONIA; LIBOR transition; risk-free rates; rational term structure models; swaptions; caplets; futures
MDPI and ACS Style

Macrina, A.; Skovmand, D. Rational Savings Account Models for Backward-Looking Interest Rate Benchmarks. Risks 2020, 8, 23.

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