A simple regime switching term structure model (Q5926474)

Many papers have extended the classical mean reversion interest rate models of \textit{O. Vasicek} [J. Financial Econ. 5, 177-188 (1977)] as well as their parametric generalization. Typically one or more additional sources of Wiener noise are introduced through the volatility parameter or through the level towards which the short rate reverts. The former approach introduces stochastic volatility interest rate models. The authors extend the short rate Vasicek model to include jumps in the local mean. They choose the computational tractable Vasicek model as their basis model and augment it by letting the level to which the process reverts change. These changes are governed by arrivals from a Poisson process. This means that jumps are presented in the drift of the short rate process. Conditions ensuring existence of a unique equivalent martingale measure are given, implying that the model is arbitrage-free and complete. Efficient numerical methods for computation of zero coupon bond prices are developed, and how the model is easily calibrated to market data is illustrated and how other interest rate derivatives can be priced are shown.