A stochastic control perspective on term structure models with roll-over risk

DOI10.1007/S00780-023-00515-ZzbMath1524.91127arXiv2304.04453MaRDI QIDQ6074008

Wolfgang J. Runggaldier, Claudio Fontana, Simone Pavarana

Publication date: 12 October 2023

Published in: Finance and Stochastics (Search for Journal in Brave)

Abstract: In this paper, we consider a generic interest rate market in the presence of roll-over risk, which generates spreads in spot/forward term rates. We do not require classical absence of arbitrage and rely instead on a minimal market viability assumption, which enables us to work in the context of the benchmark approach. In a Markovian setting, we extend the control theoretic approach of Gombani & Runggaldier (2013) and derive representations of spot/forward spreads as value functions of suitable stochastic optimal control problems, formulated under the real-world probability and with power-type objective functionals. We determine endogenously the funding-liquidity spread by relating it to the risk-sensitive optimization problem of a representative investor.

Full work available at URL: https://arxiv.org/abs/2304.04453

zbMATH Keywords

stochastic controlinterest rateliquidity riskbenchmark approachmultiplicative spreadrisk-sensitive portfolio optimisationroll-over riskterm rate

Mathematics Subject Classification ID

Optimal stochastic control (93E20) Martingales with continuous parameter (60G44) Interest rates, asset pricing, etc. (stochastic models) (91G30) Portfolio theory (91G10)

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