Week 24.02.2025 – 02.03.2025

SOFR derivatives market is still illiquid and incomplete so it is not amenable to classical risk-neutral term structure models which are based on the assumption of perfect liquidity and completeness. We develop a statistical SOFR term structure model that is well-suited for risk management and derivatives pricing within the incomplete markets paradigm. The model incorporates relevant macroeconomic factors that drive central bank policy rates which, in turn, cause random jumps often observed in the SOFR rates. The model is easy to calibrate to historical data, current market quotes, and the user’s views concerning the future development of the relevant macroeconomic factors. The model is illustrated by indifference pricing of SOFR derivatives. This is joint work with Teemu Pennanen.