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Random step functions model for interest rates

Author

Listed:
  • Eleanor Virag

    () (Department of Mathematics and Statistics, University of Melbourne, Melbourne, Victoria 3010, Australia)

  • Fima C. Klebaner

    () (Department of Mathematics and Statistics, University of Melbourne, Melbourne, Victoria 3010, Australia)

  • Konstantin Borovkov

    () (Department of Mathematics and Statistics, University of Melbourne, Melbourne, Victoria 3010, Australia)

Abstract

We propose a new model for pricing of bonds and their options based on the short rate when the latter exhibits a step function like behaviour. The model produces realistic looking spot rate curves, and allows one to derive explicit formulae for the yield curve and put and cap options. This model is appropriate for markets with pegged rates, such as the Australian market. We also give a general result on bond prices when the short rate is a sum of independent processes.

Suggested Citation

  • Eleanor Virag & Fima C. Klebaner & Konstantin Borovkov, 2003. "Random step functions model for interest rates," Finance and Stochastics, Springer, vol. 7(1), pages 123-143.
  • Handle: RePEc:spr:finsto:v:7:y:2003:i:1:p:123-143
    Note: received: July 2001; final version received: April 2002
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    More about this item

    Keywords

    Interest rates models; Markov point processes; jump processes; bonds; options on bonds;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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