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A Minimal Financial Market Model

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Abstract

The paper proposes a financial market model that generates stochastic volatilities and stochastic interest rates using a minimal number of factors that characterise the dynamics of different denominations of a benchmark portfolio. It models asset prices essentially as functionals of square root and Ornstein-Uhlenbeck processes. The resulting price processes exhibit stochastic volatility with leptokurtic log-return distributions that closely match those observed in reality. The benchmark portfolio is negatively correlated with its volatility which models the well-known leverage effect. The average growth rates of the different denominations of the benchmark portfolio are Ornstein-Uhlenbeck processes which generates the typically observed long term Gaussianity of log-returns of asset prices.

Suggested Citation

  • Eckhard Platen, 2001. "A Minimal Financial Market Model," Research Paper Series 48, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:48
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    Keywords

    stochastic volatility; financial market model; derivative pricing; square root process;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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