Abstract
The goal of this paper is to develop a reduced-form model for pricing derivatives on the overnight rate. The model incorporates jumps around central bank (CB) meetings. More specifically, rate changes are decomposed into fluctuations between CB meetings and deterministic timed jumps following CB meetings. This approach is useful for practitioners, since it allows the extraction of expectations regarding central bank decisions embedded in liquid instruments, as well as the use of these expectations for the pricing of less liquid derivatives, such as options, in a consistent manner. We discuss applications to 30-Day Fed funds options and IDI options traded in Brazil.
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