Term structure modeling under volatility uncertainty
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Publication:2120604
DOI10.1007/S11579-021-00310-4zbMATH Open1484.91496arXiv1904.02930OpenAlexW3212848174MaRDI QIDQ2120604FDOQ2120604
Authors: Julian Hölzermann 
Publication date: 1 April 2022
Published in: Mathematics and Financial Economics (Search for Journal in Brave)
Abstract: In this paper, we study term structure movements in the spirit of Heath, Jarrow, and Morton [Econometrica 60(1), 77-105] under volatility uncertainty. We model the instantaneous forward rate as a diffusion process driven by a G-Brownian motion. The G-Brownian motion represents the uncertainty about the volatility. Within this framework, we derive a sufficient condition for the absence of arbitrage, known as the drift condition. In contrast to the traditional model, the drift condition consists of several equations and several market prices, termed market price of risk and market prices of uncertainty, respectively. The drift condition is still consistent with the classical one if there is no volatility uncertainty. Similar to the traditional model, the risk-neutral dynamics of the forward rate are completely determined by its diffusion term. The drift condition allows to construct arbitrage-free term structure models that are completely robust with respect to the volatility. In particular, we obtain robust versions of classical term structure models.
Full work available at URL: https://arxiv.org/abs/1904.02930
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model uncertaintyKnightian uncertaintyterm structure of interest ratesno-arbitragerobust financeambiguous volatility
Interest rates, asset pricing, etc. (stochastic models) (91G30) Nonlinear processes (e.g., (G)-Brownian motion, (G)-Lévy processes) (60G65)
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Cited In (5)
- Volatility, risk modeling and utility
- Generalized Feynman-Kac formula under volatility uncertainty
- Reduced-form setting under model uncertainty with non-linear affine intensities
- Pricing interest rate derivatives under volatility uncertainty
- Uncertain volatility and the risk-free synthesis of derivatives
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