Affine realizations for Levy driven interest rate models with real-world forward rate dynamics
Stefan Tappe (Leibniz Universität Hannover, Germany)
Joint work with Eckhard Platen

Tuesday June 3, 16:30-17:00 | session 3.4 | Interest Rates | room K

Under the typical technical assumptions for obtaining affine realizations for Levy driven interest rate term structure dynamics, we investigate the existence of affine realizations of the forward rate dynamics under the real-world probability measure, which so far have only been studied under an assumed risk-neutral probability measure. For models driven by Wiener processes and compound Poisson processes with finite jump size distributions, all results obtained under the risk-neutral approach concerning the existence of affine realizations are transferred to the general case. However, in the presence of jumps with infinite activity we obtain severe restrictions on the structure of the market price of risk; typically, it must even be constant. Consequently, when considering the full picture of the term structure dynamics under their real-world constraints, in the case of infinite activity Levy process driven dynamics only rather restricted term structure models remain possible.

A Bond Option Pricing Formula in the Extended CIR Model, with an Application to Stochastic Volatility
Henry Schellhorn (Claremont Graduate University, USA)
Joint work with Zheng Liu and Qidi Peng

Tuesday June 3, 17:00-17:30 | session 3.4 | Interest Rates | room K

We provide a complete representation of the interest rate in the extended CIR model. Since it was proved in Maghsoodi (1996) that the representation of the CIR process as a sum of squares of independent Ornstein-Uhlenbeck processes is possible only when the dimension of the interest rate process is integer, we use a slightly different representation, valid when the dimension is not integer. Our representation consists in an infinite sum of squares of basic processes. Each basic process can be described as an Ornstein-Uhlenbeck process with jumps at fixed times. In this case, the price of a bond option resembles the Black-Scholes formula, where the normal distribution is replaced by the generalized chi-square distribution. The formula is in closed form, up to the solution of a Riccati equation for the bond price of the option. We then provide a generalization of our representation to an extended CIR model with stochastic volatility. We present a closed form approximation of the price of a bond option, valid when the expiration of the option is small and the speed of mean-reversion of volatility is high. The approximation is in 'full' closed form, i.e., it does not require to solve an ordinary differential equation.