Two-Factor Black-Karasinski Pricing Kernel
Risk.net, May 2020
Posted: 19 Jun 2020
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Two-Factor Black-Karasinski Pricing Kernel
Date Written: May 19, 2020
Abstract
Colin Turfus and Alexander Shubert present an analytic pricing kernel for a two-factor Black-Karasinski (lognormal) short-rate model as a rapidly convergent perturbation expansion valid in the limit of low rates. This expansion is used to derive analytic formulas for conditional bond prices and forward rates. The model is equally applicable to modelling credit spreads, and it satisfies the important requirement of guaranteeing positive implied default probabilities.
Keywords: Black-Karasinski, pricing kernel, perturbation expansion, asymptotic, two-factor, risk capital, scenario generation, short rate model
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