What Drives Jumps in the Secured Overnight Financing Rate? Evidence From the Arbitrage-Free Nelson–Siegel Model With Jump Diffusion

In this paper, the arbitrage-free Nelson–Siegel (NS) model with jump diffusion (AFNSJ) is proposed to describe the Secured Overnight Financing Rate (SOFR). The parameters of this model are estimated through particle filtering conducted with a weighted maximum likelihood estimation approach. The empirical results of this study indicate that the AFNSJ outperforms the arbitrage-free NS model in fitting market data. SOFR jumps are highly related to Federal Open Market Committee meetings. Moreover, even under different interest rate changes, these jumps are mainly driven by a short-term factor. The risk adjustment term can suitably capture changes in the US Federal Reserve rate caused by the jump risk component.

Keywords: Secured Overnight Financing Rate (SOFR), SOFR futures, Arbitrage-free Nelson–Siegel model with jump diffusion (AFNSJ), Federal Open Market Committee (FOMC) meeting, Particle filter

JEL Classification: C32, C51, E43, G12, G13

Suggested Citation: Suggested Citation

Fang, Dong-Jie and Yeh, Zong-Wei and He, Jie-Cao and Lin, Shih-Kuei, What Drives Jumps in the Secured Overnight Financing Rate? Evidence From the Arbitrage-Free Nelson–Siegel Model With Jump Diffusion (March 22, 2024). Pacific-Basin Finance Journal, Vol. 86, Available at SSRN: https://ssrn.com/abstract=4768825