Interest Rate Derivatives Research Articles

Impact of algorithmic trading on speed of adjustment to new information: Evidence from interest rate derivatives

AbstractIn February 2012, the Australian Securities Exchange introduced co‐location services for futures traders, thus providing a natural experiment to test the impact of algorithmic trading (AT) on the speed of adjustment and price discovery during scheduled macroeconomic releases. Our results demonstrate that, in the presence of AT, the speed of adjustment to new information has improved for both exchange‐traded futures and over‐the‐counter‐traded swaps. In addition, we find that the price discovery contribution of the futures market improves in the post‐AT period, with this improvement significant for macroeconomic announcement days.

Implicit Entropic Market Risk-Premium from Interest Rate Derivatives

Implicit in interest rate derivatives are Arrow–Debreu prices (or state price densities, SPDs) that contain funda- mental information for risk and portfolio management in interest rate markets. To extract such information from interest rate derivatives, we propose a nonparametric method to estimate state prices based on the minimization of the Cressie–Read (Entropic) family function between potential SPDs and the empirical probability measure. An empirical application of the method, in the US interest rates and derivatives market, shows that the entropic based risk-neutral density measure highlight potential risks previous to the 2007/2008 financial crisis, and the potential arbitrage burden during the Quantitative Easing period.

World trends of derivatives` market development

Derivatives markets have long ago started to be an important part of the global market in general and international monetary relations in particular. They make the process of risk management more advanced. It helps bringing the global monetary relations to a higher development level. Global trade in derivatives performs the functions of integration of regional capital markets and helps the global economy participants reduce available risks and concentrate on the further development of international trade and monetary relations. Therefore, the derivatives market contributes to reducing the risk level and balancing the international capital flow. Modern world trends in the derivatives’ market development are studied. The structure of the world derivatives market is determined with the separation of its exchange and over-the-counter parts. The instrumental structure of the market is analyzed with the separation of the most popular underlying assets among the derivatives market participants. The author notes that the share of interest rate and foreign exchange derivatives is constantly growing, with an advantage on the side of interest rate derivatives. The paper determines that there is a gradual shift of trade from exchanges to the over-the-counter market in the market of interest derivatives due to the passage of transactions through central counterparties, as well as the growing share of electronic and automatic trading. Analysis of the dynamics of foreign exchange derivatives reveals that contracts increasingly include currencies that do not belong to the top four (USD, EUR, JPY, GBP). At the same time, the US dollar remains the leading currency in operations with interest rate and foreign exchange derivatives. The cross-border operations with derivatives are analyzed. The paper proves that the global nature of the modern derivatives market can be supported by the recognition and implementation of global standards and the cooperation of regulators around the world.

The Pricing of New Interest Rate Derivative Futures

This paper reviews the development of commercial real estate mortgage-backed securities. In addition, summarizes the relevant pricing formula of futures contracts and commercial real estate mortgage-backed securities. Based on the above research, this paper puts forward a new type of interest rate derivative futures, that is to say CMBS futures. In this paper, both the CIR model and the generalized method of moments are used to deduce the relevant pricing formula of the new financial derivatives, the CMBS futures. At the same time, the 261 real commercial mortgage backed security transaction data from May 3, 2015 to April 26, 2020 in the U.S. stock market are downloaded and used to test the derived pricing formula that derived above, and at last a specific CMBS futures contract is designed in order to provide reference for publishers when they are issuing the CMBS futures products. The research of this paper has certain practical significance for promoting the interest rate marketization, broadening the existing financing channels for investors, promoting the development of interest rate derivatives market and interest rate futures market. It also has certain theoretical significance for the development of financial derivatives and futures market, especially the development of interest rate derivatives and its futures products.

Investment Sizing with Deep Learning Prediction Uncertainties for High-Frequency Eurodollar Futures Trading.

In this work we show that prediction uncertainty estimates gleaned from deep learning models can be useful inputs for influencing the relative allocation of risk capital across trades. In this way, consideration of uncertainty is important because it permits the scaling of investment size across trade opportunities in a principled and data-driven way. We showcase this insight with a prediction model and find clear outperformance based on a Sharpe ratio metric, relative to trading strategies that either do not take uncertainty into account, or that utilize an alternative market-based statistic as a proxy for uncertainty. Of added novelty is our modelling of high-frequency data at the top level of the Eurodollar Futures limit order book for each trading day of 2018, whereby we predict interest rate curve changes on small time horizons. We are motivated to study the market for these popularly-traded interest rate derivatives since it is deep and liquid, and contributes to the efficient functioning of global finance -- though there is relatively little by way of its modelling contained in the academic literature. Hence, we verify the utility of prediction models and uncertainty estimates for trading applications in this complex and multi-dimensional asset price space.

Theory of Cryptocurrency Interest Rates

A term structure model in which the short rate is zero is developed as a candidate for a theory of cryptocurrency interest rates. The price processes of crypto discount bonds are worked out, along with expressions for the instantaneous forward rates and the prices of interest-rate derivatives. The model admits functional degrees of freedom that can be calibrated to the initial yield curve and other market data. Our analysis suggests that strict local martingales can be used for modeling the pricing kernels associated with virtual currencies based on distributed ledger technologies.

A Quantum Mechanics for Interest Rate Derivatives Markets

We present an axiomatic formulation of the Option Pricing Theory for interest rates, completely analogous to axiomatic Quantum Mechanics. The role of the wave function is played in the financial theory by discounted zero-coupon bond prices. The theory is model-free and is linked to term structure models through the Hamiltonian operator. Under the quantum framework, we prove the consistency of the Schrodinger equation with the dynamics of the stochastic string model. We also find an expression for pricing options under this quantum theory, show its consistency with standard option pricing and apply the quantum formalism to Price calls and swaptions.

THE ROLE OF DERIVATIVE INSTRUMENTS IN FINANCIAL STABILITY

Globalization offers new challenges to the world economy, which becomes more depended on unprecedented in- crease of financial activity worldwide. Availability of information and development of technologies significantly increased capital flow in the world and role of capital and monetary markets in economy. Second half of 2007 and first half of 2008 faced import- ant events in the world economy. Among them especially no- table are US real estate crisis and global limitation of credits, devaluation of USD and strengthening of inflation processes. These global events have significant influence over financial stability. In the recent decade variability of stocks and interest rates, together with globalization of capital markets, in- creased demand on financial instruments with the purpose of distribution of risks. From this perspective, interest rate derivatives are most frequently marketed among OCT derivatives. Therefore, estimation of the role of financial derivatives instruments is very important in stability of international financial system. Purpose of research is to analyze influence of derivatives over financial crisis. Within frameworks of re- search 5 countries are studied for 1997-2010 quarterly. OLS regressive equation is used in research for empirical tests. Model includes following variables: crisis index (dependent variable), independent variables are: correlation rate of cur- rent account and GDP, correlation rate of domestic credit on private sector with GDP, correlation rate between foreign currency reserves and conditional amounts of market derivatives on the stock exchange. Empirical analysis shows us that influence of derivatives over financial stability is not unilateral and depends on characteristics of financial system of the country. Particularly, in Singapore and USA, where financial system is strong, influence of derivatives is positively reflected on financial stability, and empirical study conduct- ed on example of emerging markets, particularly, Argentina, Russia and Brazil revealed negative influence of derivatives on financial system.

The Cost of Clearing Fragmentation

Fragmenting clearing across multiple central counterparties (CCPs) is costly because global dealers cannot net positions across CCPs. They have to collateralize both the short position in one CCP and an offsetting long position in another CCP. This observation coupled with a structural net order imbalance across CCPs can cause prices to persistently differ across them (“the CCP basis”). We propose a model to rationalize this basis and derive several hypotheses. Testing these on unique CCP data for interest-rate derivatives, yields broad empirical support for the model and suggests that the clearing friction costs sellers clearing in LCH $80 million daily.

Impact of Algorithmic Trading on Speed of Adjustment to New Information: Evidence from Interest Rate Derivatives

This study examines the impact of algorithmic trading (AT) on the speed of adjustment and price discovery during scheduled macroeconomic announcements for interest rate derivatives. In February 2012, the Australian Securities Exchange (ASX) introduced co-location services for futures traders. This change in market structure increases AT and, in this study, we examine price efficiency for both exchange-traded futures and over-the-counter (OTC)-traded swaps in the pre- and post-AT periods. Our results demonstrate that, in the presence of AT, the speed of adjustment to new information has improved for both futures and swaps. In addition, we find that the price discovery contribution of the futures market improves in the post-AT period, with this improvement significant for announcement days. We conclude that AT stimulates market adjustment to new information and enhances the price discovery of futures on days with scheduled macroeconomic releases.

Multiplex network analysis of the UK over‐the‐counter derivatives market

AbstractIn this paper, we analyse the network of exposures constructed by using the UK trade repository data for three different categories of contracts: interest rate, credit, and foreign exchange derivatives. We study how liquidity shocks related to variation margins propagate across the network and translate into payment deficiencies across different derivative markets. A key finding of the paper is that, in extreme theoretical scenarios where liquidity buffers are small, a handful of institutions may experience significant spillover effects due to the directionality of their portfolios. Additionally, we show that two novel multiplex centrality measures, the Functional Multiplex Eigenvector Centrality and the Functional Multiplex PageRank, can be used as a proxy for the vulnerability of financial institutions, with the Functional Multiplex PageRank improving on the results that can be obtained using the Functional Multiplex Eigenvector Centrality.

Symmetry Analysis of an Interest Rate Derivatives PDE Model in Financial Mathematics

We perform Lie symmetry analysis to a zero-coupon bond pricing equation whose price evolution is described in terms of a partial differential equation (PDE). As a result, using the computer software package SYM, run in conjunction with Mathematica, a new family of Lie symmetry group and generators of the aforementioned pricing equation are derived. We furthermore compute the exact invariant solutions which constitute the pricing models for the bond by making use of the derived infinitesimal generators and the associated similarity reduction equations. Using known solutions, we again compute more solutions via group point transformations.

BACK-OF-THE-ENVELOPE SWAPTIONS IN A VERY PARSIMONIOUS MULTI-CURVE INTEREST RATE MODEL

We propose an elementary model in multi-curve setting that allows to price with simple exact closed formulas European swaptions. Swaptions can be both physical delivery and cash-settled ones. The proposed model is very parsimonious: it is a three-parameter multi-curve extension of the two-parameter J. Hull & A. White (1990) [Pricing interest-rate-derivative securities. Review of Financial Studies 3(4), 573–592] model. The model allows also to obtain simple formulas for all other plain vanilla Interest Rate derivatives and convexity adjustments. Calibration issues are discussed in detail.

Yield curves from different bond data sets

It is well known that zero coupon rates are not observable variables. Their estimation process may be cumbersome and time consuming. We explore the extent to which the set of security prices used in the yield curve construction of three popular interest rate datasets (from the Federal Reserve Board, the US Department of the Treasury, and Bloomberg) may determine the results of different analyses. Using the same US Treasury prices from GovPX and applying the same fitting technique, we estimate zero coupon rates using different baskets of assets, i.e., including/excluding bills, on-the-run, and off-the-run bonds, attempting to mimic those used by each data providers. To illustrate the uncertainty surrounding these alternatives representations of the underlying yield curve, we examine common uses of these data sets in pricing, risk management and macroeconomic purposes. We find significant and sometime overwhelming differences in the volatility term structure, the pricing of interest rate derivatives, and the correlations among different forward rates particularly in both ends of the yield curve. Relevant implications are also observed on a classic test of the expectations hypothesis. The simplest asset basket, which only includes the on-the-run bills and bonds, is probably the one with the best results.

On the Perils of Structured Loans Financing in France and Italy

AbstractThe restructuring process of sovereign debt is not yet managed under common global rules; public debt stabilisation is an explicit policy goal in the EU, but cannot be achieved if local public authorities do not control their liabilities and connected risks. EU local administrations’ debt soared due to the economic downturn, reduced resources transferred from the central state and increasing expenses. After 2000, French and Italian local authorities extensively underwrote complex financial instruments, such as over the counter (OTC) interest rate and exchange rate derivatives and structured loans (i.e. loans with embedded derivatives) to manage their growing liabilities; the proliferation of derivatives among European public administrations has been favoured by the absence of proper disclosure and of monitoring procedures. Losses due to structured loans accumulated and in 2017 French local authorities asked for state rescue; similarly, some Italian regions and municipalities reported relevant losses. The reduction of financial risks can be achieved by improving information and transparency, by reducing moral hazard, and limiting ‘revolving doors’.

Securisation Special Purpose Entities, Bank Sponsors and Derivatives

This paper documents the use of derivatives by securitisation special purpose entities (SPEs), also known as financial vehicle corporations (FVCs), domiciled in Ireland using transaction-level data established by the European Market Infrastructure Regulation. We show that these entities primarily engaged in interest rate derivatives over the period of 2015-2017. We find that larger entities that already engage in international capital markets are more likely to have derivative exposures. We also show that entities sponsored by banks and non-bank financial institutions are relatively more likely to engage in derivative markets. The characteristics of these bank sponsors are important in determining SPEs' engagement in derivative markets. SPEs' heavy reliance on debt finance coupled with their strong interconnectedness with bank sponsors underscores the importance of continuous monitoring and macroprudential surveillance of their derivative activities.

Pricing Interest Rate Derivatives after Ibor Fallback

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.

Rise and Fall of Interest Rate Futures in Indian Derivative Market

Derivative products are popular financial instruments to hedge against the risk associated with the underlying. Interest rate derivatives are the most traded and widely accepted derivative instrument in the international market. But this product is not popular in Indian derivative market. In 1999, the Over the counter (OTC) interest rate derivative products introduced in Indian derivative market. This product was successful in terms of volumes. To overcome the drawbacks of the OTC derivative market, Indian financial market introduced exchange-traded interest rate derivative in 2003, 2009 and 2014. While two times (in 2003 and 2009) this product failed, in the third time (in 2014) the initial volumes are sharply declining in three exchanges viz. MCX-SX, NSE, and BSE. In this backdrop, this study attempts to analyse the past, present, and future of interest rate futures in the Indian derivative market using the volumes, values and the open interest of Interest rate derivatives for three exchanges.

Corporate risk exposures, disclosure, and derivatives use: A longitudinal study

AbstractWe conduct firm and industry‐level examinations of key market risk exposures deemed material by managers over the period 2002–2016. We find that risk exposures have expanded in line with firms’ growth and globalization and that managers strategically select disclosure formats in recognition of firms’ demand for capital market access and need to protect proprietary information. Currency derivatives use has surpassed that of interest rate derivatives and, conditioned on a firm having the associated risk exposure, commodity derivatives use is the highest. Finally, we find large increases in risk exposures concurrent with the initiation of derivatives use.

Discounting collateral: quants, derivatives and the reconstruction of the ‘risk-free rate’ after the financial crisis

Serving as a pledge against a future promise, collateral has traditionally been understood as a ‘back office’ technicality that reduces the risk of default. Yet in the wake of the 2008 financial crisis and the erosion of faith among market participants in the credit quality of large banks, collateral is playing an increasingly important epistemic role within finance, as an anchor that underpins the valuation of a growing number of financial instruments. This paper explores the increasing importance of collateral to the modelling practices used by ‘quants’ to value ‘over-the-counter’ interest rate derivatives since the 2008 financial crisis, and how the inclusion of collateral expertise into quants’ own modelling practices has affected these markets. This historical episode suggests that while the inclusion of collateral expertise into banks’ front office modelling practices has made banks’ pricing models less abstract and more aligned to the traditionally overlooked legal practices that underpin derivatives trading, it has also led to an explosion of complexity in the valuation of these instruments that now threatens the future existence of these markets.