Price impact on term structure

Abstract

We introduce a first theory of price impact in the presence of an interest rate term structure. We explain how one can formulate instantaneous and transient price impact on zero-coupon 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 extend the price impact setup to coupon-bearing bonds and further show how to implement price impact in an HJM framework. We present pricing examples in the presence of price impact and numerical examples of how impact changes the shape of the term structure. Finally, we show that our approach is applicable by solving an optimal execution problem in interest rate markets with the type of price impact we developed in the paper.