Spike and hike modeling for interest rate derivatives: with an application to SOFR caplets

Abstract

After the replacement of Libor with alternative reference rates across the world, market participants must now adjust to a variety of changes to both contract terms and market rate dynamics. Focusing mostly on the new SOFR rate in the US, this paper considers the interaction of two important characteristics of SOFR derivatives: the backward-looking settlement style of SOFR floating rate payments; and the historically ‘jagged’ nature of SOFR time series. We introduce mechanisms that allow us to modify existing term structure models to incorporate rich dynamics for both ‘surprising’ and anticipated spikes and hikes in overnight rates. Numerical tests on SOFR-style caplets show that such model enhancements can produce significant effects on implied caplet volatility levels and skews. Besides establishing a practitioner-friendly framework for derivatives pricing, our paper is broadly applicable to scenario generation and risk management in any market with discontinuous rates dynamics.