Overnight Rate Research Articles

Total variation regularization analysis for inverse volatility option pricing problem

We investigate in this paper an inverse problem of recovering the space-dependent volatility in option pricing. To enhance precision across the domain, we transform the original problem into an inverse source problem of a bounded degenerate parabolic equation, utilizing linearization and variable substitution. Unlike classical methods, we apply a total variation regularization combined with a novel generalized finite integration technique. This approach accommodates volatility jumps in an overnight rate scenario. Leveraging an optimal control framework, we demonstrate that the inverse problem can be reformulated as an optimal control problem whose existence, necessary conditions, local uniqueness and stability for the minimizer of control functional are obtained. For numerical verification, we derive the Euler equation and design a discretization algorithm with generalized finite integration technique. Numerical examples showcase the robustness of our approach, highlighting advantages in accuracy and effectiveness over other strategies.

Drivers of the natural long-term rate of interest (and why the economy hasn’t tanked)

Abstract Long-term borrowing costs have been on a path of near continuous decline for the last several decades, with huge consequences for asset values, government finances, borrowers and savers. To shed light on why, we have estimated a global model that brings together an extensive set of drivers of the natural rate of interest for 12 advanced economies, using data spanning half a century. We find that slower growth and the age structure of the population accounted for about half of the three percentage point decline in the real natural rate for the USA between 1970 and a trough in the mid-2010s. Global spillovers account for a bit more than a third of the decline. Our model suggests the natural rate in the USA has climbed more than half a percentage point since the trough, partly reflecting extraordinary fiscal stimulus in the USA. Rather than on overnight rates, our model is estimated on 10-year borrowing costs. That is because monetary policy has increasingly relied on squeezing the whole yield curve to support demand. Importantly, when viewed through a longer-term lens, US monetary policy does not look as tight as it does when looking at short-term rates alone. This may help to explain why the economy has been so resilient to the post-pandemic hiking cycle.

Term structure modeling with overnight rates beyond stochastic continuity

AbstractOvernight rates, such as the Secured Overnight Financing Rate (SOFR) in the United States, are central to the current reform of interest rate benchmarks. A striking feature of overnight rates is the presence of jumps and spikes occurring at predetermined dates due to monetary policy interventions and liquidity constraints. This corresponds to stochastic discontinuities (i.e., discontinuities occurring at ex ante known points in time) in their dynamics. In this work, we propose a term structure modeling framework based on overnight rates and characterize absence of arbitrage in a generalized Heath–Jarrow–Morton (HJM) setting. We extend the classical short‐rate approach to accommodate stochastic discontinuities, developing a tractable setup driven by affine semimartingales. In this context, we show that simple specifications allow to capture stylized facts of the jump behavior of overnight rates. In a Gaussian setting, we provide explicit valuation formulas for bonds and caplets. Furthermore, we investigate hedging in the sense of local risk‐minimization when the underlying term structures feature stochastic discontinuities.

Short-Term Rate Benchmarks: The Post-LIBOR Regime

The London Interbank Offered Rate (LIBOR), the predominant family of global short-term rate benchmarks for the past 40 years, ceased to exist in June 2023. Given the low volumes of interbank loans on which LIBOR had been based, the revelations that LIBOR had been manipulated, and the risks that countless LIBOR-dependent financial instruments without fallback rates would be cast into limbo, regulators over the last decade pushed to replace LIBOR with risk-free overnight rate benchmarks. In the United States, the new benchmark, Secured Overnight Financing Rate (SOFR), is an overnight rate based on US Treasury repo transactions: Use of term rates and derivatives on term rates is limited, and use of credit-sensitive term rates is discouraged. This article recounts the rise and fall of LIBOR; reviews the academic literature on the efficiency benefits of benchmarks, the LIBOR scandal, and the pros and cons of risk-free versus credit-sensitive rate benchmarks; and calls for further academic work on the current policy of entrenching a single-benchmark SOFR regime relative to the alternative of encouraging a two- or multi-benchmark regime of SOFR and one or more credit-sensitive term rates.

Persistence and long memory in monetary policy spreads

ABSTRACT The overnight money market rate is a key monetary policy tool. In recent years, central banks worldwide have developed new monetary policy strategies aimed at keeping its deviations from the policy rate small and short-lived. This paper describes the main instruments used for this purpose by the US Fed, the ECB and the BoE and also their policy responses to the Great Financial Crisis (GFC). Fractional integration and long-memory methods are then applied to investigate how those affected the persistence of policy spreads (i.e. the difference between overnight rates and policy rates) during different sub-periods. It is found that this increased sharply during the GFC but has fallen back in recent years. In the case of the ECB the introduction of the new €-STR benchmark in particular appears to have made monetary policy more effective.

Does the conventional money market overnight rate influence the investment rate of Islamic deposits? Evidence from Malaysia

PurposeThe paper aims to examine whether the daily conventional money market overnight rate influences the monthly investment rate of Islamic deposits in Malaysia. The traditional approach, which averages the high-frequency data to match the low-frequency data, results in information loss for the high-frequency data.Design/methodology/approachThe paper uses the mixed data sampling (MIDAS) model to study the relationship between Islamic banking and conventional banking. The Malaysian data are used for the analysis as Malaysia has one of the most developed Islamic financial industries in the world, and it is well-known for its dual banking system.FindingsThe evidence shows that the conventional overnight rate has a positive effect on the Islamic deposit rate. The results are consistent for Islamic deposit rates with different maturities. The positive aggregate effect holds when the lag length of the daily conventional overnight rate goes up to 90 days. Additional evidence shows that the daily conventional overnight rate has a similar effect on the conventional deposit rate.Originality/valueThis paper documents that the relationship between Islamic banking and conventional banking is not monotonous. When high-frequency data is averaged with low-frequency data, the non-linear relationship will be masked. It highlights the importance of using high-frequency data to get a detailed picture.

Expected and Unexpected Jumps in the Overnight Rate: Consistent Management of the Libor Transition

Interest-rate benchmark reform has revived short-rate modelling. One reason is that short-rate models provide a consistent framework in which different benchmarks, and contracts linked to them, can be compared. Another reason is that new benchmarks can be directly dependent on very short-term rates; the key example is a backward-looking compounding of overnight rates, a prominent alternative to forward-looking Libor. Indeed, under Libor, one can often safely ignore aspects of short-rate behaviour, especially jumps. At least partially for this reason, jumps are inadequately treated in the interest-rate literature, particularly expected jumps (jumps with known timing). We estimate a model with expected and unexpected jumps, which involves separating their effect on term rates. We then price forward- and backward-looking caplets, quantifying the spread exhibited by the latter over the former. Expected jumps lead to significantly time-inhomogeneous option behaviour, particularly for short-term options linked to a backward-looking benchmark.

Overnight rate and signalling effects of central bank bills

We analyse the impact of interest-bearing central bank bills on financial market variables in Switzerland. The unique institutional setting allows us to identify the causal effects of two orthogonal shocks occurring on days with central bank bill auctions through heteroscedasticity: an overnight interest rate shock and a signalling shock. The first shock raises the overnight interest rate and modestly appreciates the exchange rate. The signalling shock appreciates the exchange rate more strongly. In addition, it lowers stock prices, long-term interest rates, as well as inflation expectations, and it raises corporate bond spreads. The signalling shock is economically more important for forward-looking variables than the overnight rate shock. The results suggest that liquidity-absorbing operations between official monetary policy decisions affect financial market variables by revealing information about the central bank’s future policy actions.

Cross-border payments, global imbalances and involuntary constraints

Investigations into the process by which cross-border payments are completed within the international monetary system remain largely unresolved. By exploring how these payments are executed through a flow of funds representation as per Institutional Practice—the operations of both the Central Bank and commercial banks within the payment and settlement system—this paper will (1) demonstrate that domestic monetary policy implementation entails the Central Bank offsetting all autonomous reserve flows to maintain an overnight policy rate; (2) show why global imbalances occur and persist across the international monetary system; and (3) outline the impact of involuntary constraints on policymaking.

Short Rate Dynamics: A Fed Funds and SOFR perspective

The Secured Overnight Funding Rate (SOFR) is becoming the main Risk–Free Rate benchmark in US dollars, thus interest rate term structure models need to be updated to reflect the key features exhibited by the dynamics of SOFR and the forward rates implied by SOFR futures. Historically, interest rate term structure modelling has been based on rates of substantially longer time to maturity than overnight, but with SOFR the overnight rate now is the primary market observable. This means that the empirical idiosyncrasies of the overnight rate cannot be ignored when constructing interest rate models in a SOFR–based world. As a rate reflecting transactions in the Treasury overnight repurchase market, the dynamics of SOFR are closely linked to the dynamics Effective Federal Funds Rate (EFFR), which is the interest rate most directly impacted by US monetary policy target rate decisions. Therefore, these rates feature jumps at known times (Federal Open Market Committee meeting dates), and market expectations of these jumps are reflected in prices for futures written on these rates. On the other hand, forward rates implied by Fed Funds and SOFR futures continue to evolve diffusively. The model presented in this paper reflects the key empirical features of SOFR dynamics and is calibrated to futures prices. In particular, the model reconciles diffusive forward rate dynamics with piecewise constant paths of the target short rate.

Expected and Unexpected Jumps in the Overnight Rate: Consistent Management of the Libor Transition

Expected and Unexpected Jumps in the Overnight Rate: Consistent Management of the Libor Transition

Efectos asimétricos en la relación de los precios bursátiles con el tipo de cambio, los precios mundiales del petróleo y la tasa de interés ante la pandemia de Covid-19

En este artículo se analiza cómo ha sido la influencia del tipo de cambio, los precios mundiales del petróleo y la tasa de interés interbancaria de equilibrio (TIIE) a un día sobre el Índice de Precios y Cotizaciones (IPC) de la Bolsa Mexicana de Valores durante el brote de Covid-19, el periodo de confinamiento y el inicio del regreso a la nueva normalidad en México. Mediante un modelo ARDL no lineal (NARDL) se consideran los efectos asimétricos de esas variables sobre el indicador bursátil de diciembre del año pasado al primer semestre de 2020, encontrando que, al menos para el periodo bajo estudio, para explicar el comportamiento bursátil es pertinente considerar efectos diferenciados (asimétricos) en los efectos de las variables enunciadas.

Interest rates, income distribution and the monetary policy transmissions mechanism under endogenous money: what have we learned 30 years on from Horizontalists and Verticalists?

This paper suggests that the near-optimal setting of the real policy rate of interest (the real overnight rate in Basil Moore's home country of Canada) is zero. This will achieve as close an approximation as possible to a fair distribution of income in a particular sense. It will also promote financial stability, inflation stability, high growth, full employment and higher real wages.

Monetary Policy, Income Inequality, and Inflation — What’s the Link?

This paper studies the link in Canada between monetary policy, income inequality, and inflation. What are the effects of monetary policy on income inequality? and why and how does inflation play a role? Income inequality largely increased from the time the Bank of Canada began targeting inflation, through the late 1990s to the early 2000s, and flattened or decreased after the 2008 financial crisis. On the whole, income inequality today is greater than it was when the Bank of Canada became an inflation-targeting central bank. Against this backdrop, our analysis shows that expansionary monetary policy shocks, triggered by a lower than expected bank rate, lead to increasing income inequality, while contractionary monetary policy shocks reduce income inequality. We then show that these effects are asymmetric with expansionary shocks having a greater impact on income inequality than contractionary shocks. Expansionary monetary policy shocks result in a higher share of national income shifting to higher income households, who consume less as a percentage of their income, dampening the increase in aggregate demand, and, therefore, inflation. Our results lead to one particularly important conclusion for monetary policy: namely, that the Bank of Canada needs to account for the impact of income inequality when modeling how inflation will respond to a change in the overnight rate.

DETERMINANT OF GOVERNMENT BOND YIELDS

This study aims to analyze the influence of determinant factors: (i) exchange rates, (ii) inflation, (iii) CDS spreads, (iv) bid-ask spreads, (v) overnight rate, (vi) CB’s rate (Central Bank Rate), and (vii) oil prices on Government bond yields. The data used are monthly data in the period 2012 - 2018. The research method used is the Vector Auto Regression (VAR) approach. Our analysis indicated that the determinant factors have impact on government bond yields. Based on the analysis of the impulse response function (IRF), the yield is to respond to any shocks given by the long term. While through forecast error variance decomposition (FEVD) analysis, found that CDS spreads and oil prices contributed significantly to the movement of Government bond yields.

Persistence and Long Memory in Monetary Policy Spreads

The overnight money market rate is a key monetary policy tool. In recent years, central banks worldwide have developed new monetary policy strategies aimed at keeping its deviations from the policy rate small and short-lived. This paper describes the main instruments used for this purpose by the US Fed, the ECB and the BoE and also their policy responses to the Great Financial Crisis (GFC). Fractional integration and long-memory methods are then applied to investigate how those affected the persistence of policy spreads (i.e., the difference between overnight rates and policy rates) during different sub-periods. It is found that this increased sharply during the GFC but has fallen back in recent years. In the case of the ECB the introduction of the new €-STR benchmark in particular appears to have made monetary policy more effective.

Water in the Wine? Monetary Policy and the Impact of Non-bank Financial Intermediaries

Canada was lauded for surviving the 2007-08 global financial crisis relatively unscathed. In part, this was due to the success of our financial services sector. This resilience, especially in contrast to the US banking sector, is partly explained by the smaller size of the non-bank financial intermediation (NBFI) sector in Canada – more popularly known as “shadow banking.” But signs of robust growth in Canada’s NBFI sector after the crisis suggest this resilience might be under threat. The assets of those institutions engaged in non-bank financial intermediation have continued to grow in Canada since the global financial crisis, and now account for a larger share of total financial assets than prior to the crisis. A more important NBFI sector has multiple effects on the financial system and on the economy. On the one hand, intermediaries in the sector, or NBFIs, provide alternatives for both depositors and borrowers that improve the functioning of the economy by increasing competition. On the other hand, they also might increase vulnerabilities, since they are often not as closely regulated, and deposit insurance does not cover their liabilities. We find that, as NBFI deposit growth increases in importance, it can dilute the effectiveness of monetary policy. This drag might be the result of depositors shifting between NBFIs and traditional banks, an effect that is exacerbated as the NBFI sector grows. We also find that contractionary monetary policy causes an increase in business credit growth for NBFIs and a fall in chartered bank business loan growth. Although the overall effect on business credit growth is the desired decrease, the increase in NBFI business loans both decreases monetary policy effectiveness and results in a riskier composition. Lastly, we find the insignificant effect on overall mortgage credit growth following a contractionary monetary policy shock appears to be driven by a shift of credit from traditional banks to NBFIs, and could be a concern from a financial stability perspective. Overall, these results highlight the importance of a growing NBFI sector for monetary policy and financial stability. Our findings suggest that both the traditional monetary policy tool of the overnight rate and tightening mortgage underwriting standards through macroprudential policy might have the unintended side effect of increasing financial instability. One way to reduce this potential side effect is to limit the migration of loans between traditional banks and NBFIs by tightening regulation of NBFIs to level the playing field between the two types of financial institutions. At a minimum, the systemically important NBFIs should face capital requirements and underwriting standards similar to those imposed on traditional banks. We hope these results help the Bank of Canada as it continues to evaluate and model the evolution of monetary policy transmission in the Canadian economy. To that end, NBFIs should be front and centre when the four coordinating bodies that provide systemic financial services oversight next meet.

Abstract P2035: Severity of Hypertension Due to Elastin Haploinsufficiency is Sex-Dependent

William syndrome, an autosomal-dominant disease, is caused partly by loss-of-function mutations or gene macro-deletions resulting in elastin ( Eln ) haploinsufficiency. A major hallmark of Eln haploinsufficiency is hypertension, accompanied by arteriopathy and tortuous and elongated vessels. Previously, we showed that hypertension due to Eln haploinsufficiency in mice is due at least partly to abnormal remodeling of renal vascular signaling and increased blood pressure sensitivity to dietary salt observed only in male Eln +/- mice. In this study, we tested the hypothesis that ovarian hormones protect against excessive blood pressure increase resulting from Eln haploinsufficiency and blood pressure sensitivity to dietary salt in female mice. We used radiotelemetry to acquire diurnal blood pressure (BP) and heart rate (HR) before and after oophorectomy (OVX) in female wild type and Eln +/- mice. Four weeks after OVX, mice were placed on normal or high salt diet for 10 days, with continual acquisition of telemetry BP and HR. We assessed renal function by measuring urinary excretion of creatinine, sodium and potassium. Expression of sodium transporters was assessed by Western blot. Prior to OVX, baseline BP was elevated in Eln +/- mice (WT: 114 ± 3 vs. Eln +/- : 128 ± 8 mmHg; p =0.08). This was accompanied by a marked decrease in sodium/chloride co-transporter activity (phospho-NCC) and total-NCC in Eln +/- kidneys and a trend towards increased expression of epithelial sodium channel (ENaC)-alpha and beta isoforms, and decreased trend in overnight urinary sodium excretion rate (WT: 579 ± 95 vs. Eln +/- : 439 ± 82 μmol/h/g KW). Four weeks after OVX, BP was further elevated in Eln +/- mice (WT: 119 ± 7 vs. Eln +/- : 151 ± 10 mmHg; p <0.01) but was not further elevated by chronic high-salt diet (OVX + NS Eln +/- : 151 ± 10 vs. OVX + HS Eln +/- : 131 ± 5 mmHg; p =0.12). OVX also caused a robust increase in ENaC expression in Eln +/- kidneys, whereas the same effect was seen in WT kidneys only after OVX plus high salt diet. We conclude that ovarian hormones suppress blood pressure elevation attributed to Eln haploinsufficiency and protect against blood pressure sensitivity to increased dietary sodium consumption.

Reaction of Overnight Rate to Its Determinants Under 'Normal' Situation and During the Financial Turmoil of 2007-2009

We analyze the reaction of the spread between the overnight rate and the target rate to Central Banks’ instruments during normal time and the Subprime crisis. By using US, UK and Euro area data, we estimate the dynamic of these spread with an asymmetric EGARCH model. Our results reveal that most of the modifications of these instruments have reduced the volatility of the spreads. In situation marked by liquidity risks, as during the first phase of this crisis, these Banks managed to control the overnight rate. Conversely, in situation marked with credit risks, as after the collapse of Lehman Brothers, the control of this rate was harder even when unconventional measures alleviated the pressure on markets and reduce the volatility of the spreads.

Tenor-Based Interest Rate Term Structures: Roll-Over Risk Perspective

Modelling the risk that a financial institution may not be able to roll over its debt at the market reference rate, the so–called “roll–over risk”, we construct a model framework for the dynamics of reference term rates (e.g., LIBOR) and their spread vis–a–vis benchmarks based on overnight reference rates, e.g., rates implied by overnight index swaps (OIS). In this framework, different interest rate term structures are endogenously generated for each tenor, that is, a different term structure for each choice of the length of the interest rate accrual period, be it overnight (e.g., OIS), three–month LIBOR, six–month LIBOR, etc. A concrete model instance in this framework can be calibrated simultaneously to available market instruments at a particular point in time, but more importantly, we explicitly obtain dynamics of term rates such as LIBOR. Thus models in our framework are amenable to econometric estimation. For a model class based on affine dynamics, we conduct an empirical analysis on EUR data for OIS, interest–rate swaps, basis swaps and credit default swaps. Our model achieves a better fit to time series data than other models proposed in prior literature. We find that credit risk typically contributes only about 30% of the IBOR/OIS spread, with the balance of the spread due to the funding liquidity component of roll–over risk. Looking ahead, we show that, even if credit risk is entirely mitigated by repo transactions, the presence of roll–over risk confounds attempts to obtain term rates from overnight rate benchmarks. As various jurisdictions transition away from panel–based term rate benchmarks towards transaction–based overnight ones (such as SOFR in the United States), the framework presented in this paper thus provides important insights into some of the consequences of this transition.