Interest rate derivatives in a CTMC setting: Pricing, replication and Ross recovery
We consider a financial market in which the short rate is modeled by a continuous time Markov chain (CTMC) with a finite state space. In this setting, we show how to price any financial derivative whose payoff is a function of the state of the underlying CTMC at the maturity date. We also show how to replicate such claims by trading only a money market account and zero-coupon bonds. Finally, using an extension of Ross’ Recovery Theorem due to Qin and Linetsky, we deduce the real-world dynamics of the CTMC.
Authors
- Matthew Lorig (ORCID: https://orcid.org/0000-0001-5307-3447)
- Tim Leung (ORCID: https://orcid.org/0000-0002-0023-6289)
Institutions
- University of Washington Applied Physics Laboratory (US)
Publication Details
- Journal
- International Journal of Financial Engineering
- Published
- 2025-09-19
- DOI
- https://doi.org/10.1142/s2424786325500173
- Primary Topic
- Stochastic processes and financial applications
- Type
- article
- Field-Weighted Citation Impact
- 0.00