A heat kernel approach to interest rate models

DOI10.1007/S13160-014-0147-3MaRDI QIDQ403855zbMATH OpenOpenAlexFDO

Authors Jirô Akahori, Yuji Hishida, Josef Teichmann, Takahiro Tsuchiya

Publication date 29 August 2014

Published in Japan Journal of Industrial and Applied Mathematics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/0910.5033

zbMATH Keywords

Markov-functionalstate price density

Mathematics Subject Classification ID

Heat kernel (35K08) PDEs in connection with game theory, economics, social and behavioral sciences (35Q91) PDEs with randomness, stochastic partial differential equations (35R60) Continuous-time Markov processes on general state spaces (60J25)

Abstract: We construct default-free interest rate models in the spirit of the well-known Markov funcional models: our focus is analytic tractability of the models and generality of the approach. We work in the setting of state price densities and construct models by means of the so called propagation property. The propagation property can be found implicitly in all of the popular state price density approaches, in particular heat kernels share the propagation property (wherefrom we deduced the name of the approach). As a related matter, an interesting property of heat kernels is presented, too.

Review text

The paper is meant as a presentation of the heat kernel approach in the construction of state price densities. The idea of the approach is the following: For a Markov process \((X_t)_t\), assume that one can easily compute expectations \(\mathbb E [f(X_t)]\) and one explicitly knows one additional function \(p\) depending on time and the state variables; then one can construct explicit formulae for bond prices, and analytically tractable formulae for caps, swaptions and other derivatives: by this it is meant that these formulae can be calculated by one numerical integration with respect to the law of the underlying Markov process. This approach can be easily calibrated to market data, and is efficient in the modelling of interest rates with jumps, but not only. The basic concepts are presented with great detail, as well as many illuminating examples

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Cites work

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Cited in

(6)

• Randomised mixture models for pricing kernels
• Heat kernel models for asset pricing
• Polynomial term structure models
• Rational multi-curve models with counterparty-risk valuation adjustments
• The affine rational potential model
• Generalizations of Ho-Lee's binomial interest rate model II: randomization

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