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.

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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
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article

Interest rate derivatives in a CTMC setting: Pricing, replication and Ross recovery

Matthew Lorig, Tim Leung
International Journal of Financial Engineering
Stochastic processes and financial applications
article

Interest rate derivatives in a CTMC setting: Pricing, replication and Ross recovery

Matthew Lorig, Tim Leung
article en

Abstract

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.

International Journal of Financial EngineeringVol. 12(04)
University of Washington Applied Physics Laboratory (US)
Openalex Percentile: Top 67%
Stochastic processes and financial applications
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