COHERENT CHAOS INTEREST-RATE MODELS

Dorje C. Brody () and Stala Hadjipetri ()
Additional contact information
Dorje C. Brody: Department of Mathematics, Brunel University, Uxbridge UB8 3PH, UK;
Stala Hadjipetri: Department of Mathematics, Imperial College London, London SW7 2AZ, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2015, vol. 18, issue 03, 1-27

Abstract: The Wiener chaos approach to interest-rate modeling arises from the observation that in the general context of an arbitrage-free model with a Brownian filtration, the pricing kernel admits a representation in terms of the conditional variance of a square-integrable generator, which in turn admits a chaos expansion. When the expansion coefficients of the random generator factorize into multiple copies of a single function, the resulting interest-rate model is called "coherent", whereas a generic interest-rate model is necessarily "incoherent". Coherent representations are of fundamental importance because an incoherent generator can always be expressed as a linear superposition of coherent elements. This property is exploited to derive general expressions for the pricing kernel and the associated bond price and short rate processes in the case of a generic nth order chaos model, for each n ∈ ℕ. Pricing formulae for bond options and swaptions are obtained in closed form for a number of examples. An explicit representation for the pricing kernel of a generic incoherent model is then obtained by use of the underlying coherent elements. Finally, finite-dimensional realizations of coherent chaos models are investigated and we show that a class of highly tractable models can be constructed having the characteristic feature that the discount bond price is given by a piecewise-flat (simple) process.

Keywords: Pricing kernel; conditional variance representation; Wiener chaos expansion; Fock space; coherent states (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024915500168
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:18:y:2015:i:03:n:s0219024915500168

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024915500168

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().