A Fractal Version of the Hull-White Interest Rate Model

Abstract:     
This paper develops a new version of the Hull-White's model of interest rates, in which the volatility of the short term rate is driven by a Markov switching multifractal model. The interest rate dynamics is still mean reverting but the constant volatility of the Brownian motion is replaced by a multifractal process so as to capture persistent volatility shocks. In this setting, we infer properties of the short term rate distribution, a semi closed form expression for bond prices and their dynamics under a forward measure. Finally, our work is illustrated by a numerical application in which we assess the exposure of a bonds portfolio to the interest risk.

Number of Pages in PDF File: 19

Keywords: Hidden Markov process, switching Brownian motion, Interest rates

JEL Classification: C5

working papers series