Modeling Exchange-Traded Short-Term Rate Futures and Options

Summary

The document asks whether exchange-traded short-term interest rate futures and their options have a standard modeling framework comparable to SABR extensions of the Libor Market Model used for over-the-counter derivatives. Its focus is the difference between markets built around forwards and typically European options, and exchange-traded futures with options that may be American. The question also asks how effectively a model can capture the volatility smile while valuing American exercise.

The response emphasizes that liquid exchange-traded instruments often serve as calibration building blocks for OTC products because they are used for hedging. It cautions that models for liquid markets may be empirical and need not have the classical arbitrage-free structure used in risk-neutral OTC valuation. The answer is brief and does not name a particular model, offer calibration details, or resolve how to jointly handle American exercise and smile dynamics. It therefore frames the modeling distinction rather than prescribing a valuation method.

Key ideas

• Exchange-traded short-term rate futures and options differ from OTC forward-based derivatives in their contract and exercise features.
• Liquid futures and options can act as calibration building blocks for OTC instruments because they support hedging.
• The response characterizes many liquid-market models as empirical rather than classically arbitrage-free.
• The discussion does not specify a particular model for American options or volatility smile calibration.

Tags

# Term structure model for exchange-traded STIR futures and their options


# Term structure model for exchange-traded STIR futures and their options












As I understand, models such as the SABR extension of the Libor Market Model are the "standard" for interest rate derivative valuation in OTC markets, where options tend to be European and it is forwards (not futures) being traded.

In practice, is there an equivalent modelling framework for the exchange-traded market (e.g. CME Eurodollar futures and their options), where options tend to be American and the instruments are futures, not forwards?

I know that simple discrete term-structure models can be used to value American options, but I'm not sure that any can incorporate the volatility smile with the same effectiveness as SABR.

## Answer by ExIR (score 1)

https://quant.stackexchange.com/a/45665

Liquid market instruments tend to be "building blocks", i.e. the OTC instruments need be "calibrated" to them, since futures/options etc are used in hedging OTC. OTC instruments are valued in risk neutral or equivalent martingale measures, but liquid markets are in physical measure. One can build some models to tackle the liquid markets, but not in the classical "arb-free" sense. In others, empirical models only.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.