Random step functions model for interest rates (Q1424709)

The authors propose a new model of pricing of bonds and their options based on the short rate when the latter exhibits a step function like behaviour. The paper concentrates on deriving explicit formulas for prices of bonds and their options for the random step function model of the rates. The model is flexible, simple, well-specified, realistic, and can be fitted to data. Very general and rigorous theoretical results on a class of models with jumps are presented. It is argued that for any model in which the short rate process is assumed to be the sum of several independent processes, the bond price is a product of the prices calculated for the (sub)models corresponding to each individual component. Examples for applications of this result include jump-diffusion models as well as general Lévy processes for the short rate. A form of yield curves and put and cup options are given for some special cases of RSF model, in particular for marked Poisson process model.