Looking Forward to Backward-Looking Rates: A Modeling Framework for Term Rates Replacing LIBOR

24 Pages Posted: 5 Mar 2019

See all articles by Andrei Lyashenko

Andrei Lyashenko

Quantitative Risk Management, Inc.

Fabio Mercurio

Bloomberg L.P.

Date Written: February 6, 2019

Abstract

In this paper, we define and model forward risk-free term rates, which appear in the payoff definition of derivatives, and possibly cash instruments, based on the new interest-rate benchmarks that will be replacing IBORs globally. We show that the classical interest rate modeling framework can be naturally extended to describe the evolution of both the forward-looking (IBOR-like) and backward-looking (setting-in-arrears) term rates using the same stochastic process. In particular, we show that the extension of the popular LIBOR Market Model (LMM) to the backward-looking rates completes the model by providing additional information about the rate dynamics not accessible in the LMM.

Keywords: IBOR replacement, RFR, SOFR, LMM, market model, forward rates

JEL Classification: C22, C60, G12, G13

Suggested Citation

Lyashenko, Andrei and Mercurio, Fabio, Looking Forward to Backward-Looking Rates: A Modeling Framework for Term Rates Replacing LIBOR (February 6, 2019). Available at SSRN: https://ssrn.com/abstract=3330240 or http://dx.doi.org/10.2139/ssrn.3330240

Andrei Lyashenko

Quantitative Risk Management, Inc. ( email )

181 W. Madison St
Chicago, IL 60602
United States

Fabio Mercurio (Contact Author)

Bloomberg L.P. ( email )

731 Lexington Avenue
New York, NY 10022
United States

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