A chaotic approach to interest rate modelling (Q1776025): Difference between revisions

The authors propose a new approach to interest rate dynamics when a general family of arbitrage-free positive interest rate models, valid on all time horizons, is considered. A discount bond system is supposed to be driven by a Brownian motion, possibly multidimensional. The space of such models is canonically mapped to the space of square-integrable Wiener functionals. Then the Wiener chaos expansion technique is used to formulate a systematic analysis of the structure and classification of interest rate models. The specification of a first-chaos model is shown to be equivalent to the specification of an admissible initial yield curve. A comprehensive development of the second-chaos interest rate theory is presented in the case of a single Brownian factor. The factorisable second-chaos models are particularly tractable and lead to closed-form expressions for options on bonds and for swaptions. A general ``international'' model for interest rates and foreign exchange is outlined. It is proved that the entire system can be generated by a vector of Wiener functionals.