An interest rate model with upper and lower bounds (Q1421690)

In this paper, the authors study a new interesting dynamic model \(r_t\) described by the following stochastic differential equation \[ dr_t=\alpha(r_{\mu}-r_t)\,dt+ \beta\sqrt{(r_t-r_m)(r_M-r_t)}\,dW_t \] with positive \(\alpha,\beta\) and \(r_m<r_{\mu}<r_M,\) which garantee the existence of a stationary distribution. The moment evaluation formula of the interest rate and the arbitrage free pure discount bond price formula by a weighted series of Jacobi polynomials are derived. Lower and upper bounds for the arbitrage free discount bond price are given. It is also shown that the numerical evaluation procedure converges to the exact value in the limit and the accuracy of the approximation formulas for the discount bond prices is evaluated. This type of diffusion, so-called Jacobi diffusion or Jacobi process, has already been known and studied in genetics. The same model was studied by \textit{T. Fujita} [Asia-Pac. Finan. Mark. 9, No. 3-4, 211--215 (2002; Zbl 1059.91039)] using the perturbation method. The present paper uses a spectral method.