Forward rate dynamics are modeled as a random field. In contrast to multifactor models, random field models offer a parsimonious description of term structure dynamics, while eliminating the self-inconsistent practice of recalibration. The form of the drift of the instantaneous forward rate process necessary to preclude arbitrage under the risk-neutral measure is obtained. Forward risk-adjusted measures are identified and used to price a bond option when the forward volatility structure depends on the square root of the current spot rate. Several classes of tractable random field models are presented. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
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Article provided by Oxford University Press for Society for Financial Studies in its journal Review of Financial Studies.
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