Pricing Interest Rate Derivatives after Ibor Fallback

Abstract

In this paper, I introduce and define interest rate models for pricing interest rate derivatives in ibor fallback environment. July 2017 Andrew Bailey, the CEO of the U.K. Financial Conduct Authority (FCA), speech on The future of LIBOR contains that there is an increased expectation that some IBOR benchmarks will be discontinued in the near future. On July 12, 2018, ISDA published a consultation on benchmark fallbacks to market participants, and on the end of 2018, published the final results of new benchmark fallbacks for interest rate derivatives contracts that reference certain IBORs. As a result, quantitative analysts, risk managers and financial system engineers have been forced to develop fallback rate dynamics that model new benchmark fallbacks of the final results published by ISDA and evaluate interest rate derivatives corresponding to the fallback rate. Furthermore, they have to evaluate both ibor based interest rate derivatives contracted before ibor fallback and ones after it for ibor fallback environment. I show that fallback rate dynamics can be described with extending the classic interest rate models, and the dynamics can be available for pricing interest rate derivatives in ibor fallback environment.