Semi-Markov regime switching interest rate models and minimal entropy measure

Julien Hunt and Pierre Devolder

Physica A: Statistical Mechanics and its Applications, 2011, vol. 390, issue 21, 3767-3781

Abstract: In this paper, we present a discrete time regime switching binomial-like model of the term structure where the regime switches are governed by a discrete time semi-Markov process. We model the evolution of the prices of zero-coupon when given an initial term structure as in the model by Ho and Lee that we aim to extend. We discuss and derive conditions for the model to be arbitrage free and relate this to the notion of martingale measure. We explicitly show that due to the extra source of uncertainty coming from the underlying semi-Markov process, there are an infinite number of equivalent martingale measures. The notion of path independence is also studied in some detail, especially in the presence of regime switches. We deal with the market incompleteness by giving an explicit characterization of the minimal entropy martingale measure. We give an application to the pricing of a European bond option both in a Markov and semi-Markov framework. Finally, we draw some conclusions.

Keywords: Semi-Markov; Regime switching; Interest rates; Discrete time; Ho and Lee; Absence of arbitrage; Incompleteness; Minimal entropy; Martingale measure; Bond options; Non-recombining paths (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (8)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:phsmap:v:390:y:2011:i:21:p:3767-3781

DOI: 10.1016/j.physa.2011.04.036

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