Price Impact on Term Structure

TL;DR

This paper develops a theoretical framework for understanding how price impact affects the term structure of interest rates, integrating it with no-arbitrage principles and demonstrating practical implications through pricing and optimal execution examples.

Contribution

It introduces a novel theory of price impact in interest rate markets, including cross impact and its integration with no-arbitrage pricing.

Findings

Price impact can be embedded in the pricing measure.

Impact influences the shape of the term structure.

The approach is applicable to optimal execution problems.

Abstract

We introduce a first theory of price impact in presence of an interest-rates term structure. We explain how one can formulate instantaneous and transient price impact on bonds with different maturities, including a cross price impact that is endogenous to the term structure. We connect the introduced impact to classic no-arbitrage theory for interest rate markets, showing that impact can be embedded in the pricing measure and that no-arbitrage can be preserved. We present pricing examples in presence of price impact and numerical examples of how impact changes the shape of the term structure. Finally, to show that our approach is applicable we solve an optimal execution problem in interest rate markets with the type of price impact we developed in the paper.