Markov-Functional Interest Rate Models
Phil J. Hunt
Citigroup - Global Corporate and Investment Banking Group (GCIB)
University of Warwick - Department of Statistics
Maastricht University; Netspar
October 5, 1999
We introduce a general class of interest rate models in which the value of pure discount bonds can be expressed as a functional of some (low-dimensional) Markov process. At the abstract level this class includes all current models of practical importance. By specifying these models in Markov-functional form, we obtain a specification which is efficient to implement. An additional advantage of Markov-functional models is the fact that the specification of the model can be such that the forward rate distribution implied by market option prices can be fitted exactly, which makes these models particularly suited for derivatives pricing. We give examples of Markov-functional models that are fitted to market prices of caps/floors and swaptions.
Number of Pages in PDF File: 25
JEL Classification: G13
Date posted: January 12, 1998
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