Short Rate Dynamics: A Fed Funds and SOFR perspective

34 Pages Posted: 19 Feb 2021

See all articles by Karol Gellert

Karol Gellert

University of Technology Sydney (UTS) - Quantitative Finance Research Centre

Erik Schlögl

University of Technology Sydney (UTS), Quantitative Finance Research Centre; University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management; Faculty of Science, Department of Statistics, University of Johannesburg; Financial Research Network (FIRN)

Date Written: January 11, 2021

Abstract

The Secured Overnight Funding Rate (SOFR) is becoming the main Risk–Free Rate benchmark in US dollars, thus interest rate term structure models need to be updated to reflect the key features exhibited by the dynamics of SOFR and the forward rates implied by SOFR futures. Historically, interest rate term structure modelling has been based on rates of substantially longer time to maturity than overnight, but with SOFR the overnight rate now is the primary market observable. This means that the empirical idiosyncrasies of the overnight rate cannot be ignored when constructing interest rate models in a SOFR–based world.

As a rate reflecting transactions in the Treasury overnight repurchase market, the dynamics of SOFR are closely linked to the dynamics Effective Federal Funds Rate (EFFR), which is the interest rate most directly impacted by US monetary policy target rate decisions. Therefore, these rates feature jumps at known times (Federal Open Market Committee meeting dates), and market expectations of these jumps are reflected in prices for futures written on these rates. On the other hand, forward rates implied by Fed Funds and SOFR futures continue to evolve diffusively. The model presented in this paper reflects the key empirical features of SOFR dynamics and is calibrated to futures prices. In particular, the model reconciles diffusive forward rate dynamics with piecewise constant paths of the target short rate.

Keywords: SOFR, EFFR, Fed Funds, interest rate term structure modelling, interest rate futures

JEL Classification: G13, G18, E43

Suggested Citation

Gellert, Karol and Schloegl, Erik, Short Rate Dynamics: A Fed Funds and SOFR perspective (January 11, 2021). FIRN Research Paper Forthcoming, Available at SSRN: https://ssrn.com/abstract=3763589 or http://dx.doi.org/10.2139/ssrn.3763589

Karol Gellert

University of Technology Sydney (UTS) - Quantitative Finance Research Centre ( email )

P.O. Box 123
Sydney
Australia

Erik Schloegl (Contact Author)

University of Technology Sydney (UTS), Quantitative Finance Research Centre ( email )

Ultimo
PO Box 123
Sydney, NSW 2007
Australia
+61 2 9514 2535 (Phone)

HOME PAGE: http://www.schlogl.com

University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management ( email )

Leslie Commerce Building
Rondebosch
Cape Town, Western Cape 7700
South Africa

Faculty of Science, Department of Statistics, University of Johannesburg ( email )

Auckland Park, 2006
South Africa

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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