Tag Archives: model risk

Life below zero – the impact of negative rates on derivatives activity

James Purchase and Nick Constantine.

In 1995, Fischer Black, an economist whose ground-breaking work in financial theory helped revolutionise options trading, confidently stated that “the nominal short rate cannot be negative.”  Twenty years later this assumption looks questionable: one quarter of world GDP now comes from countries with negative central bank policy rates.  Practitioners have been forced to update their models accordingly, in many cases introducing greater complexity.  But this shift is not just academic.  Models allowing for a wider distribution of future rates require market participants to hedge against greater uncertainty.  We argue that this hedging contributed to the volatility in global rates in early 2015, but that derivatives can also play an important role in facilitating monetary policy transmission at negative rates.

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Filed under Financial Markets, Market Infrastructure, Monetary Policy, New Methodologies