TY - JOUR

T1 - Term Structure Modeling of SOFR

T2 - Evaluating the Importance of Scheduled Jumps

AU - Schlögl, Erik

AU - Skov, Jacob Bjerre

AU - Skovmand, David

N1 - Publisher Copyright: © 2024 World Scientific Publishing Company.

PY - 2024

Y1 - 2024

N2 - 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). This effect 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.

AB - 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). This effect 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.

KW - FOMC

KW - futures

KW - jumps

KW - SOFR

U2 - 10.1142/S0219024924500092

DO - 10.1142/S0219024924500092

M3 - Journal article

AN - SCOPUS:85197889813

JO - International Journal of Theoretical and Applied Finance

JF - International Journal of Theoretical and Applied Finance

SN - 0219-0249

M1 - 2450009

ER -