Bond pricing in a hidden Markov model of the short rate (Q5926472)

This paper deals with a model for the short-term interest rate. Today there exists a vast literature on diffusion type models for the short rate. It ranges from time-homogeneous single-factor models, over time-inhomogeneous single-factor models and log-normal model, and all the way to multi-factor models. There are also short rate models which leave the diffusion setting, i.e. they allow other driving processes than Brownian motion. In this paper it is assumed that the short rate dynamics are driven by a Brownian motion, but it is allowed the drift and diffusion parameters to be modulated by an underlying Markov process. It is sometimes known as a hidden Markov process. In econometric papers it is sometimes referred to as a regime-switching model. In this paper it is specified the model directly under the martingale measure and the main objective is to study how bond pricing can be carried out within this framework both when the underlying process is observable and when it is not. It turns out that pricing in this context may be viewed as a filtering problem.