Premium
The Potential Approach to the Term Structure of Interest Rates and Foreign Exchange Rates
Author(s) -
Rogers L. C. G.
Publication year - 1997
Publication title -
mathematical finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.98
H-Index - 81
eISSN - 1467-9965
pISSN - 0960-1627
DOI - 10.1111/1467-9965.00029
Subject(s) - yield curve , simple (philosophy) , interest rate , term (time) , econometrics , yield (engineering) , markov process , exchange rate , foreign exchange , mathematical economics , process (computing) , markov chain , forward rate , economics , computer science , mathematics , macroeconomics , statistics , monetary economics , physics , quantum mechanics , philosophy , materials science , epistemology , metallurgy , operating system
It is possible to specify a model for interest rates in various ways, by giving the dynamics of the spot rate or of the forward rates, for example. A less well–developed approach is to specify the law of the state–price density process directly. In abstract, the state–price density process is a positive supermartingale, and the theory of Markov processes provides a rich framework for the generation of examples of such things. We show how this can be done, and provide simple examples (some familiar, some new) where prices of derivatives can be computed very easily. One benefit of the potential approach is that it becomes very easy to model the yield curve in many countries at once, together with the exchange rates between them.