Short-Rate Derivatives in a Higher-for-Longer Environment

Aram Karakhanyan, Takis Konstantopoulos, Matthew Lorig and Evgenii Samutichev

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Abstract: We introduce a class of short-rate models that exhibit a ``higher for longer'' phenomenon. Specifically, the short-rate is modeled as a general time-homogeneous one-factor Markov diffusion on a finite interval. The lower endpoint is assumed to be regular, exit or natural according to boundary classification while the upper endpoint is assumed to be regular with absorbing behavior. In this setting, we give an explicit expression for price of a zero-coupon bond (as well as more general interest rate derivatives) in terms of the transition density of the short-rate under a new probability measure, and the solution of a non-linear ordinary differential equation (ODE). We then narrow our focus to a class of models for which the transition density and ODE can be solved explicitly. For models within this class, we provide conditions under which the lower endpoint is regular, exit and natural. Finally, we study two specific models -- one in which the lower endpoint is exit and another in which the lower endpoint is natural. In these two models, we give an explicit solution of transition density of the short-rate as a (generalized) eigenfunction expansion. We provide plots of the transition density, (generalized) eigenfunctions, bond prices and the associated yield curve.

Date: 2025-02
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