Year: 2025
Type: article
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.
Authors: Tim Leung, Matthew Lorig
Institution: University of Washington
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
OpenAlex ID: W4414370480