Bond Pricing under Knightian Uncertainty. A Short Rate Model with Drift and Volatility Uncertainty

Julian Hölzermann
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Julian Hölzermann: Center for Mathematical Economics, Bielefeld University

No 582, Center for Mathematical Economics Working Papers from Center for Mathematical Economics, Bielefeld University

Abstract: It is shown how to construct an arbitrage-free short rate model under uncertainty about the drift and the volatility. The uncertainty is represented by a set of priors, which naturally leads to a G-Brownian motion. Within this framework, it is shown how to characterize the whole term structure without admitting arbitrage. The pricing of zero-coupon bonds in such a setting differs substantially from the traditional models, since the prices need to be chosen in a different way in order to exclude arbitrage.

Keywords: Robust Finance; Knightian Uncertainty; Short Rate Model; No-Arbitrage (search for similar items in EconPapers)
Pages: 23
Date: 2018-08-13
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https://pub.uni-bielefeld.de/download/2930378/2930379 First Version, 2018 (application/pdf)

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Persistent link: https://EconPapers.repec.org/RePEc:bie:wpaper:582

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