Joanne Kennedy () (Department of Statistics, University of Warwick, Coventry CV4 7AL, United Kingdom) Phil Hunt () (Global Derivatives and Fixed Income Markets, Westdeutsche Landesbank Girozentrale, 33/36 Gracechurch Street, London EC3V 0AX, United Kingdom) Antoon Pelsser () (Structured Products Group , ABN-Amro Bank, P.O. Box 283, 1000 EA Amsterdam, The Netherlands and Department of Finance, Erasmus University Rotterdam, P.O. Box 1738, 3000 DR Rotterdam, The Netherlands Manuscript)
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We introduce a general class of interest rate models in which the value of pure discount bonds can be expressed as a functional of some (low-dimensional) Markov process. At the abstract level this class includes all current models of practical importance. By specifying these models in Markov-functional form, we obtain a specification which is efficient to implement. An additional advantage of Markov-functional models is the fact that the specification of the model can be such that the forward rate distribution implied by market option prices can be fitted exactly, which makes these models particularly suited for derivatives pricing. We give examples of Markov-functional models that are fitted to market prices of caps/floors and swaptions.
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Find related papers by JEL classification: G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
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