Short-rate models with stochastic discontinuities: a PDE approach

Abstract: With the reform of interest rate benchmarks, interbank offered rates (IBORs) like LIBOR have been replaced by risk-free rates (RFRs), such as the Secured Overnight Financing Rate (SOFR) in the U.S. and the Euro Short-Term Rate (\euro STR) in Europe. These rates exhibit characteristics like jumps and spikes that correspond to specific market events, driven by regulatory and liquidity constraints. To capture these characteristics, this paper considers a general short-rate model that incorporates discontinuities at fixed times with random sizes. Within this framework, we introduce a PDE-based approach for pricing interest rate derivatives and establish, under suitable assumptions, a Feynman-Ka\v{c} representation for the solution. For affine models, we derive (quasi) closed-form solutions, while for the general case, we develop numerical methods to solve the resulting PDEs.