An application of short rate modelling involving roll-over risk to caplet pricing

Montgomery, Thomas

An application of short rate modelling involving roll-over risk to caplet pricing

Master Thesis

2022

Abstract

The concept of roll-over risk encapsulates the risk that a bank sitting on an interbank panel may be unable to borrow at the interbank overnight reference rate at some point in the future. Roll-over risk is comprised of two separate risks: the risk that the bank may deteriorate in credit quality relative to the 'average' bank sitting on the interbank panel and the risk that the bank may experience worse liquidity than the 'average' panel bank. Roll-over risk has been offered as a possible explanation of basis spreads which have proliferated since the Global Financial Crisis. This dissertation makes use of the established methods in order incorporate rollover risk in the pricing of a caplet based on an underlying reference rate. The caplet pricing function is compared to traditional discretised Monte Carlo techniques. The performance of the function proves more accurate and computationally efficient.

Keywords

finance and tax

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