The Curious Case of Backward Short Rates
15 Pages Posted: 20 Jan 2021 Last revised: 16 Mar 2021
Date Written: November 11, 2020
In this paper, we discuss how to discretize continuous-time short rate models in order to properly handle backward-looking interest rate derivatives. We show that the popular discretization approaches are based on forward-looking one-period rates, making them intrinsically ill-suited to deal with backward-looking rates. We propose a simple backward discretization approach that is beneficial when dealing with both backward-looking and forward-looking interest rate derivatives.
Keywords: IBOR Replacement, RFR, Short Rate Models, Backward-Looking Rates
JEL Classification: C22, C60, G12, G13
Suggested Citation: Suggested Citation