Derivative practitioners need to be thinking about the pricing and modeling challenges related to prolonged, and in some areas, increasingly negative rate environments around the globe. The recent March 22 announcement by the Bank of Hungary—along with the January 29th announcement by the Bank of Japan—to adopt negative interest rates took much of the world by surprise. Of particular interest to derivative market participants, the info graphic below highlights the negative market rates in Europe and Japan for 2-year bond yields, as of March 21, 2016.

Negative rates are continuing to impact some of the most basic calculations and procedures used by the financial community.   Financial institutions are facing challenges, as a consistent modelling framework is needed to capture negative rates and to have correct PnL and accurate risk assessment.

In the current low interest rate environment—especially in Europe and Japan where many deposit rates are below zero and many market rates hover in negative territory—financial institutions are finding that their option models do not handle negative rates. And, since dealing with negative strikes and forwards for short maturity caps and swaptions may require firms to modify their whole implementation of cap and swaption volatility surfaces, this has become a critically important issue.

The Financial Times had not too long ago reported that declines in European interest rates into negative territory could profoundly affect the workings of the entire financial system. With February 16th marking the official date negative rates went into effect in Japan (Note: market rates for 2-year bond yields have also dipped into negative territory), what could this move mean for the Japanese economy—and derivative market participants as a whole, looking toward the remainder of 2016 and beyond? How many other Central Banks could follow suit in the near future, and what could this mean for the markets—and for additional challenges with derivatives pricing and modeling in particular?

Do negative interest rates really work as an effective economic strategy? Clearly, there are mixed feelings regarding the use of negative interest rates by central banks as a tool to move money back into their economies—once other options have been exhausted. The growing presence of negative rates, is indeed somewhat remarkable when just five years ago the concept of a negative interest rate was so implausible that most derivative pricing models were designed to work exclusively with positive rates. The persistent negative rate environment continues to highlight two prominent derivative-related challenges – the quotation of option volatilities and volatility smile interpolation models, such as SABR.

Considered revolutionary in helping to solve some of the derivative modeling challenges related to negative rates was the recent introduction of the Free Boundary SABR model by Dr. Alexandre Antonov. In the paper, "The Free Boundary SABR: Natural Extension to Negative Rates," written by Numerix quantitative researchers, Dr. Alexandre Antonov, Dr. Michael Konikov and Dr. Michael Spector, the authors outline how the widely used SABR model can be extended to incorporate a "free boundary" SABR process, more naturally permitting negative rates versus a shifted SABR process, and eliminating the arbitrary lower bound on rates.

Learn More about how to solve the derivative pricing and modelling challenges with this collection of research and insights on Negative Rates from Numerix experts.