Interest rates and information geometry

DOI10.1098/RSPA.2000.0722MaRDI QIDQ2748083zbMATH OpenOpenAlexWikidataFDO

Authors Dorje C. Brody, Lane P. Hughston

Publication date 6 February 2003

Published in Proceedings of the Royal Society of London. Series A. Mathematical, Physical and Engineering Sciences (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1111.3757

zbMATH Keywords

densityinterest rate dynamicsterm structureyield curves

Mathematics Subject Classification ID

Methods of local Riemannian geometry (53B21)

Abstract: The space of probability distributions on a given sample space possesses natural geometric properties. For example, in the case of a smooth parametric family of probability distributions on the real line, the parameter space has a Riemannian structure induced by the embedding of the family into the Hilbert space of square-integrable functions, and is characterised by the Fisher-Rao metric. In the nonparametric case the relevant geometry is determined by the spherical distance function of Bhattacharyya. In the context of term structure modelling, we show that minus the derivative of the discount function with respect to the maturity date gives rise to a probability density. This follows as a consequence of the positivity of interest rates. Therefore, by mapping the density functions associated with a given family of term structures to Hilbert space, the resulting metrical geometry can be used to analyse the relationship of yield curves to one another. We show that the general arbitrage-free yield curve dynamics can be represented as a process taking values in the convex space of smooth density functions on the positive real line. It follows that the theory of interest rate dynamics can be represented by a class of processes in Hilbert space. We also derive the dynamics for the central moments associated with the distribution determined by the yield curve.

Review text

It is shown that, in the context of term structure modelling, the derivative of the discount function with respect to the time left until maturity gives rise to a probability density (this is due to the positivity of interest rates). The density functions associated with a given family of term structures can be mapped to a suitable Hilbert space. The resulting metrical geometry can then be used to analyze the relationship of yield curves to one another. Then it is shown that the general arbitrage-free yield-curve dynamics is representable as a process taking values in the convex space of smooth density functions on the real line. This, in turn, implies that the theory of interest rate dynamics can be represented by a class of processes in Hilbert space. As a consequence the dynamical laws of the first moment and the second central moment of an admissible, arbitrage-free term structure are derived.

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