Negative Interest Rates Effects on Option Pricing: Back to Basics?

Abstract

We provide the first formal investigation of the consequences of negative interest rates in the Eurozone on the pricing of interest rate options. Since the money market rates settled in negative territory and other market segments experienced negative yields, the broader financial community has had to face an unknown environment. The well-known Black-Scholes framework has become unfeasible for interest rate option valuation. First of all, no-arbitrage properties are breached, allowing arbitrage opportunities. More, the Black-Scholes framework’s assumption of a log-normal distribution of the underlying rates does not stand with negative interest rates. Currently, more banks are trading a wide number of options without a reliable price. Each bank could handle this problem by performing its own solution, but the lack of a shared approach could lead to serious legal issues.

We argue that the most notable approach which allows interest rate option pricing is Bachelier’s (1900), which assumes a normal distribution of the underlying rates. We demonstrate that the Bachelier model represents an answer to the critical issues that are raised in our study. Still, we highlight that it is far from being an accurate pricing model. Our research aims to light up an intense debate about alternative solutions among academics, financial professionals and institutions, and policy makers.

Keywords: Option pricing, Negative Interest Rates, Black-Scholes framework, Bachelier model

JEL Classification: G13, G23