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Negative rates are rewriting the rules of modern finance
By Brandon Kochkodin
Monday, September 30,2019
Negative interest rates have quite literally broken one of the pillars of modern finance.
As economists and central bankers weigh the pros and cons of sub-zero rates and their impact on the world, traders have been contending with a rather more mundane, but fundamental issue: How to price risk on trillions of dollars of financial instruments like interest-rate swaps when their complex mathematical models simply don’t work with negative numbers.
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Out are certain variations of the Black-Scholes model, the framework that allowed derivatives to flourish in the past four decades. In are a hodgepodge of approximations and workarounds, including one dating to the 19th century.
Granted, the current state of affairs is more a nuisance than a serious problem. And it's one that has been largely confined to Europe and Japan. But with sub-zero interest rates becoming a long-term economic feature and the number of negative-yielding bonds reaching $15 trillion, it's an issue more and more traders, particularly in the U.S., are trying to wrap their heads around. ...
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