How should I think about modelling instruments when interest rates can be negative?

Question

AcadiFi · Accepted Answer

Negative rates force you to revisit model assumptions that quietly relied on positivity. A standard lognormal setup can become awkward because it does not naturally accommodate negative underlying rates. That is why practitioners often consider alternatives such as normal-rate models, shifted lognormal specifications, or frameworks built directly around the shape of the full curve.

Suppose Harbor Peak ALM is managing a portfolio of rate-sensitive liabilities in a market where short maturities drift below zero. If the desk insists on a plain positive-only rate model, valuation and hedge sensitivities may become distorted. A shifted process or a normal-style framework may better fit observed option prices and curve behavior.

The FRM takeaway is not that one model is permanently correct. It is that model choice has to match market reality and instrument behavior. This is especially important for option risk because implied volatility surfaces can react differently once rates cross zero. Candidates should ask three questions: can the model represent observed rates, does it preserve sensible pricing dynamics, and does it support the risk sensitivities the desk actually uses? Negative-rate environments are a reminder that model convenience is never a substitute for empirical fit in live markets. Practice more in our FRM question bank.

How should I think about modelling instruments when interest rates can be negative?

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