The original thinking about this paper was motivated by some discussion we had many years ago with Professor Tomas Björk: it is a pleasure to acknowledge our debt. We would also like to thank the anonymous referees for some valuable suggestions which helped to considerably improve the paper.
ARBITRAGE-FREE MULTIFACTOR TERM STRUCTURE MODELS: A THEORY BASED ON STOCHASTIC CONTROL
Article first published online: 19 JUN 2012
© 2012 Wiley Periodicals, Inc.
Volume 23, Issue 4, pages 659–686, October 2013
How to Cite
Gombani, A. and Runggaldier, W. J. (2013), ARBITRAGE-FREE MULTIFACTOR TERM STRUCTURE MODELS: A THEORY BASED ON STOCHASTIC CONTROL. Mathematical Finance, 23: 659–686. doi: 10.1111/j.1467-9965.2012.00527.x
- Issue published online: 5 AUG 2013
- Article first published online: 19 JUN 2012
- Manuscript received September 2010; final revision received August 2011.
- multifactor term structures;
- bond option pricing;
- stochastic control
We present an alternative approach to the pricing of bonds and bond derivatives in a multivariate factor model for the term structure of interest rates that is based on the solution of an optimal stochastic control problem. It can also be seen as an alternative to the classical approach of computing forward prices by forward measures and as such can be extended to other situations where traditionally a change of measure is involved based on a change of numeraire. We finally provide explicit formulas for the computation of bond options in a bivariate linear-quadratic factor model.