Markov-functional interest rate models

Joanne Kennedy (), Phil Hunt () and Antoon Pelsser
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Joanne Kennedy: Department of Statistics, University of Warwick, Coventry CV4 7AL, United Kingdom
Phil Hunt: Global Derivatives and Fixed Income Markets, Westdeutsche Landesbank Girozentrale, 33/36 Gracechurch Street, London EC3V 0AX, United Kingdom

Finance and Stochastics, 2000, vol. 4, issue 4, 408 pages

Abstract: We introduce a general class of interest rate models in which the value of pure discount bonds can be expressed as a functional of some (low-dimensional) Markov process. At the abstract level this class includes all current models of practical importance. By specifying these models in Markov-functional form, we obtain a specification which is efficient to implement. An additional advantage of Markov-functional models is the fact that the specification of the model can be such that the forward rate distribution implied by market option prices can be fitted exactly, which makes these models particularly suited for derivatives pricing. We give examples of Markov-functional models that are fitted to market prices of caps/floors and swaptions.

Keywords: Yield curve modelling; derivatives pricing; Markov processes (search for similar items in EconPapers)
JEL-codes: E43 G13 (search for similar items in EconPapers)
Date: 2000-08-11
Note: received: June 1999; final version received: August 1999
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Citations: View citations in EconPapers (23)

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