Discrete-Time Interest Rate Modelling

Lane Hughston () and Andrea Macrina ()
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Lane Hughston: Department of Mathematics, Imperial College
Andrea Macrina: Department of Mathematics, King's College London, Institute of Economic Research, Kyoto University

No 691, KIER Working Papers from Kyoto University, Institute of Economic Research

Abstract: This paper presents an axiomatic scheme for interest rate models in discrete time. We take a pricing kernel approach, which builds in the arbitrage-free property and pro- vides a link to equilibrium economics. We require that the pricing kernel be consistent with a pair of axioms, one giving the inter-temporal relations for dividend-paying as- sets, and the other ensuring the existence of a money-market asset. We show that the existence of a positive-return asset implies the existence of a previsible money-market account. A general expression for the price process of a limited-liability asset is derived. This expression includes two terms, one being the discounted risk-adjusted value of the dividend stream, the other characterising retained earnings. The vanishing of the latter is given by a transversality condition. We show (under the assumed axioms) that, in the case of a limited-liability asset with no permanently-retained earnings, the price process is given by the ratio of a pair of potentials. Explicit examples of discrete-time models are provided.

Keywords: Interest rates models; pricing kernels; financial time series; Flesaker-Hughston models; transversality condition; financial bubbles (search for similar items in EconPapers)
Pages: 7pages
Date: 2010-01
New Economics Papers: this item is included in nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:kyo:wpaper:691

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