Modelling the Term Structure of Interest Rates a la Heath-Jarrow-Morton but with Non-Gaussian Fluctuations

Abstract:     
We consider a generalization of the Heath-Jarrow-Morton model for the term structure of interest rates where the forward rate is driven by Paretian fluctuations. We derive a generalization of Ito's lemma for the calculation of a differential of a Paretian stochastic variable and use it to derive a Stochastic Differential Equation for the discounted bond price.

We show that it is not possible to choose the parameters of the model to ensure absence of drift of the discounted bond price. Then we consider a Continuous Time Random Walk with jumps driven by Paretian random variables and we derive the large time scaling limit of the jump probability distribution function (pdf). We show that under certain conditions defined in text the large time scaling limit of the jump pdf in the Fourier domain is \tilde{\omega}_t(k,t) \sim \exp{ -\mathfrak{K}/(\ln(k t))^2 } and is different from the case of a random walk with Gaussian fluctuations.

Number of Pages in PDF File: 18

Keywords: Stochastic differential equations, Ito's lemma, Term structure of interest rates, Pricing of financial derivatives, Scaling limits of Continuous Time Random Walks, Steepest descent approximation

working papers series