Forward Shooting the Backward-Looking Rate: The Implications of LIBOR Cessation

As a result of LIBOR (London Interbank Offered Rate) rigging scandal, the benchmark rate is being phased out and replaced by compounded overnight rates based on more secured transactions (for example, Secured Overnight Financing Rate, SOFR for dollar-denominated derivatives and loans).

The backward-looking methodology of compounded overnight rates introduces path-dependency problem to tree valuation of floating rate payoffs. As with path-dependency modelling in finite difference method, we circumvented this by introducing an extra dimension to the tree in order to represent the state of accumulated compounding. Motivated by Forward Shooting Grid (FSG) numerical method of Barraquand and Pudet (1994), we attempted to obtain the relation of this augmented state to the stochastic variable of (1-factor) Hull-White model of interest rates. We were able to show convergence of FSG for both linear as well as non-linear payoffs and the numerical method can thus be used to price callable notes referencing the new benchmark rate.

Forward Shooting the Backward-Looking Rate: The Implications of LIBOR Cessation

Fill out the form below to download.