Analytic risk-free rates option pricing with smile and skew
An arbitrage-free short-rate model for backward-looking compounded rates is presented
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Colin Turfus and Aurelio Romero-Bermudez extend their 2021 short-rate model to facilitate accurate arbitrage-free analytic pricing of Secured Overnight Financing Rate (SOFR), Sterling Over Night Index Average (Sonia) or euro short-term estimated rate (ESTR) caplets (ie, options on backward-looking compounded rates payments) in a manner consistent with the smile and skew levels observed in the market. These caplet pricing formulas are presented as effective
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