On the Effect of ESTER Discounting on the Pricing and Risk of EUR-denominated Interest Rate Derivatives

Christopher Ramstad & Jonatan Høg

Student thesis: Master thesis


The objective of this paper is to investigate the possible effects of the transition from EONIA to ESTER discounting on the pricing and risk of EUR-denominated interest rate derivatives. To this end, several short rate models have been utilised to model the evolution of the underlying interest rates. Specifically, the Vasicek model, the Hull-White one-factor model, and the G2++ model have been applied. Furthermore, the G2++ model has been modified to a dual-curve setup, where the six month Euribor and EONIA rates have been modelled concurrently. Swaps and swaptions as examples of specific financial instruments relying on these interest rates have then been priced using the simulated short rate paths. Subsequently, the model has been shocked in a number of different ways to mimic some of the possible effects of changing to ESTER discounting. These shocks included expected changes to the level, the volatility and possible effects of a negative correlation between the two interest rates. To examine the consequences of the shocks the new simulated short rate paths have been used to price the same instruments again. This study indicates that the implementation of the ESTER most likely will incur a non-negligible transfer of value between certain types of instruments. As the transition to ESTER was not known at the time of settlement for many of the outstanding contracts, this transfer can be viewed as unfair. Consequently, several ways including possible cash compensation to mitigate the value transfer have been discussed. However, no obvious solution satisfying every market participant was apparent.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2020
Number of pages143