Sparse Representation of Overnight Indexed Interest Rate Curves

Marcos Carreira (ICMC-USP)

Abstract: Interpolation methods must be judged by their performance on hedging custom dates with market instruments. By using knowledge about the dynamics of monetary policy actions and the structure of Overnight Indexed Futures and Swaps, an interpolation method can be used not only to improve hedging performance but also to generate a sparse representation of the Overnight Indexed curve. It is also shown that the number and location of these anchor points (and their change over time) can be used to classify scenarios, with applications in risk management. We will discuss briefly the applications in option pricing using the implied transition matrices.