The Potential Approach to Bond and Currency Pricing
37 Pages Posted: 17 Apr 1999
Date Written: March 8, 1999
The pricing kernel, or the state-price density, which relates future cash flows to today's price, is the fundamental building block of modern asset pricing theory. In abstract, the state-price density process can be regarded as a positive supermartingale, or, under some regularity conditions, a potential. The theory of Markov processes provides a rich framework for the generation of examples of potentials. In this paper, we begin the modeling of bond and currency prices from the modeling of the state-price density satisfying basic properties of a potential. We provide extensive examples on the potential modeling of the state-price densities and their implications on bond and currency pricing. We show that most classic interest rate models are special cases of this general approach. We also investigate the connection between the potential approach and the Heath, Jarrow, and Morton approach widely used in the finance area. One advantage of the potential approach resides in its great ease in modeling the yield curves of many countries at the same time, together with the exchange rates between them. We derive the properties of exchange rates under each example and illustrate their possibility in explaining the forward premium puzzle.
JEL Classification: G12, G13, G15, E43, C60
Suggested Citation: Suggested Citation