Critical analysis of the most widespread methodologies for the simulation of the short rate dynamics under extreme market conditions

Abstract

This study proposes an analysis of the main drawbacks emerged when adopting the traditional short rate dynamics under extreme market conditions such as under negative interest rates. In fact, this condition has led to invalidate the use of the majority of the most popular stochastic differential equations (SDE) reported in the scientific literature. The first part of the paper makes an overall introduction to the problem, analyzing it from different perspectives. Given that the author dealt with these topics in previous research items, the objective of the paper is to focus on only one of these aspects which was not scrutinized before and to examine it in full detail. As a result, the most popular stochastic dynamics are shown in the second part and the problems raised by their numerical integration are then discussed. Starting from the equations for which it is feasible to implement a numerical scheme for their solution, the problem thus becomes how to find a reasonable estimation for the SDE parameters. The third section deals with the problems occurred in the application of Maximum Likelihood Estimation (MLE) caused by the negative interest rates during the implementation of the well-established approaches. For every analyzed dynamics a real market case is provided. The paper highlights the appropriateness of the Hull-White model which can be considered a feasible and reliable solution for simulating short rates also under extreme market conditions.