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ARBITRAGE-FREE MULTIFACTOR TERM STRUCTURE MODELS: A THEORY BASED ON STOCHASTIC CONTROL

Authors


  • 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.

Andrea Gombani, Corso Stati Uniti 4, 35127 Padova, Italy; e-mail: gombani@isib.cnr.it.

Abstract

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.

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