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The Potential Approach to Bond and Currency Pricing

Author

Listed:
  • Markus Leippold

    (University of St.Gallen)

  • Liuren Wu

    (Fordham University New York)

Abstract

In this paper, we begin the modeling of bond and currency prices from the modeling of the state-price density satisfying basic properties of a potential. We provide extensive examples and show their implications on bond and currency pricing. Most classic short rate models are special cases of this general approach. We also investigate the connection to the Heath, Jarrow, and Morton model. One advantage of the potential approach resides in its ease in simultaneously modeling the yield curves of many countries and their exchange rates. The properties of exchange rates under each example are derived and we illustrate their possibility in explaining the forward premium puzzle.

Suggested Citation

  • Markus Leippold & Liuren Wu, 1999. "The Potential Approach to Bond and Currency Pricing," Finance 9903004, EconWPA.
  • Handle: RePEc:wpa:wuwpfi:9903004
    Note: Type of Document - LaTex; prepared on IBM PC - PC-TEX; to print on HP/PostScript; pages: 50; figures: none. none
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    References listed on IDEAS

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    1. David Backus & Silverio Foresi & Chris Telmer, 1996. "Affine Models of Currency Pricing," NBER Working Papers 5623, National Bureau of Economic Research, Inc.
    2. Hodrick, Robert J. & Srivastava, Sanjay, 1986. "The covariation of risk premiums and expected future spot exchange rates," Journal of International Money and Finance, Elsevier, vol. 5(1, Supple), pages 5-21, March.
    3. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters,in: Theory Of Valuation, chapter 5, pages 129-164 World Scientific Publishing Co. Pte. Ltd..
    4. Robert E. Cumby & Maurice Obstfeld, 1984. "International Interest Rate and Price Level Linkages under Flexible Exchange Rates: A Review of Recent Evidence," NBER Chapters,in: Exchange Rate Theory and Practice, pages 121-152 National Bureau of Economic Research, Inc.
    5. David K. Backus & Silverio Foresi & Chris Telmer, "undated". "Discrete time models of bond pricing," GSIA Working Papers 251, Carnegie Mellon University, Tepper School of Business.
    6. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305 World Scientific Publishing Co. Pte. Ltd..
    7. Constantinides, George M, 1992. "A Theory of the Nominal Term Structure of Interest Rates," Review of Financial Studies, Society for Financial Studies, vol. 5(4), pages 531-552.
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    9. Kaushik I. Amin & Robert A. Jarrow, 2008. "Pricing foreign currency options under stochastic interest rates," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 14, pages 307-326 World Scientific Publishing Co. Pte. Ltd..
    10. Ho, Thomas S Y & Lee, Sang-bin, 1986. " Term Structure Movements and Pricing Interest Rate Contingent Claims," Journal of Finance, American Finance Association, vol. 41(5), pages 1011-1029, December.
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    14. Backus, David & Foresi, Silverio & Mozumdar, Abon & Wu, Liuren, 2001. "Predictable changes in yields and forward rates," Journal of Financial Economics, Elsevier, vol. 59(3), pages 281-311, March.
    15. Brennan, Michael J. & Schwartz, Eduardo S., 1979. "A continuous time approach to the pricing of bonds," Journal of Banking & Finance, Elsevier, vol. 3(2), pages 133-155, July.
    16. Lars Peter Hansen & Robert J. Hodrick, 1983. "Risk Averse Speculation in the Forward Foreign Exchange Market: An Econometric Analysis of Linear Models," NBER Chapters,in: Exchange Rates and International Macroeconomics, pages 113-152 National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:

    1. Leippold, Markus & Wu, Liuren, 2002. "Asset Pricing under the Quadratic Class," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(02), pages 271-295, June.
    2. Markus Leippold & Liuren Wu, 2002. "Design and Estimation of Quadratic Term Structure Models," Finance 0207014, EconWPA.
    3. Gibson, Rajna & Lhabitant, Francois-Serge & Talay, Denis, 2010. "Modeling the Term Structure of Interest Rates: A Review of the Literature," Foundations and Trends(R) in Finance, now publishers, vol. 5(1–2), pages 1-156, December.

    More about this item

    Keywords

    Potential approach; Interest Rate; Currency; International Term Structure Models; Heath-Jarrow-Morton; Forward Premium Puzzle;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General

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