The Reduced Form Approach to SOFR Swap and Swaption Valuation

05/23/2022 11:01 AM

The Reduced Form Approach to SOFR Swap and Swaption Valuation
Risk Americas, May 11, 2022
Robert A. Jarrow[1] and Donald R. van Deventer[2]
This Version: May 19, 2022

Abstract
We present an annotated version of slides used in a presentation to Risk Americas on the reduced form approach to SOFR swap and swaptions valuation. The same methodology can be used for any floating rate swap index from Libor to Treasury bills and to any new short-term index that may emerge in the years ahead. The contents of the slides were co-authored by Prof. Jarrow and Mr. van Deventer. The annotated comments which follow reflect comments from the podium by Mr. van Deventer or additional remarks that reflect the newer data used in this version and comments from conference participants received after the original presentation.

From an academic point of view, Prof. Jarrow often comments that a model based on false assumptions should be rejected.  From a practitioner point of view, a model based on false assumptions cannot be rejected until a more accurate replacement model is available. This presentation is candid in its assessment of models in common use for swaptions valuation and practical in replacing false assumptions with alternatives that fit observable market prices perfectly.

The full presentation is available here:
https://www.kamakuraco.com/2022/05/19/the-reduced-form-approach-to-sofr-swap-and-swaption-valuation/

Comments and suggestions are welcome at info@kamakuraco.com.|
[1] Samuel Curtis Johnson Graduate School of Management, Cornell University, Ithaca, N.Y. 14853 and Kamakura Corporation, Honolulu, Hawaii 96815. Email: raj15@cornell.edu
[2] Kamakura Corporation, Honolulu, Hawaii 96815. Email dvandeventer@kamakuraco.com