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A stochastic monetary policy interest rate model Claudio Albanese
 

Summary: A stochastic monetary policy interest rate model
Claudio Albanese
claudio@level3finance.com
Manlio Trovato
Merrill Lynch
manlio trovato@ml.com
May 3, 2007
Abstract
We present a three factor interest rate term structure model solved on
a continuous-time lattice and constructed with local volatility, asymmetric
jumps, stochastic volatility regimes and stochastic monetary policy.
We take the 3-month spot LIBOR rate as modelling primitive. An
analysis of the historical data suggests that the process is subject to drift
regimes. As the 3-month spot LIBOR rate is not an asset price process,
the drift is not constrained by the no-arbitrage condition. We incorpo-
rate a direct specification of the drift process in our model: this is a
novel approach in interest rate modelling and it represents one of the
main contributions of this work. The model can be formally written as
dLt = ľat (Lt)dt + bt (Lt)dWt + jumps where the drift and the volatility
terms are stochastic and driven by the processes at, bt, correlated to the

  

Source: Albanese, Claudio - Department of Mathematics, King's College London

 

Collections: Mathematics