LIBOR Reform: Option Pricing for Compounded Rates

32 Pages Posted: 1 Mar 2021 Last revised: 21 Jun 2022

See all articles by Andreas Bloechlinger

Andreas Bloechlinger

University of Applied Sciences Northwestern Switzerland

Date Written: June 21, 2022

Abstract

I present new analytical pricing formulae for derivatives of compounded rates. Since the replacement of LIBOR, the compounded overnight rate has become the new market standard for floating-rate loans and notes. Many contracts contain a zero-based floor. The compounded rate is a time average of a series of benchmark rates. Floors and caps on compounded rates are thus Asian types of options. I prove that even if the rate process is non-Gaussian, the Gaussian process is asymptotically the correct model for pricing derivatives due to Lyapunov's central limit theorem. The approximation's maximum mispricing is bounded by the Berry-Esseen inequality.

Keywords: Benchmark Rate Reform, Interest Rate Derivative, Asian Option, Central Limit Theorem, Zero Lower Bound

JEL Classification: E43, G13, C46

Suggested Citation

Bloechlinger, Andreas, LIBOR Reform: Option Pricing for Compounded Rates (June 21, 2022). Available at SSRN: https://ssrn.com/abstract=3780968 or http://dx.doi.org/10.2139/ssrn.3780968

Andreas Bloechlinger (Contact Author)

University of Applied Sciences Northwestern Switzerland ( email )

Riggenbachstrasse 16
Olten, Solothurn 4600
Switzerland

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