A Unified Paradigm of Interest-Rate Modeling

Peter C. L. Lin
(Stevens Institute of Technology, Department of Mathematical Sciences, Castle Point, Hoboken, NJ 07030, USA)

Abstract: Prices of assets and their derivatives are congruent, yet practitioners price them separately, especially in the fixed-income market where quantitative models are constructed within disconnected ivory towers. This research proposes a unified paradigm for the term structure of interest rate: from a financial aspect, the model must provide a pricing mechanism for both the underlying assets and their derivatives; from a mathematical aspect, the model must show the internal consistency under different measures; from a computational aspect, the model must come equipped with a (pseudo) closed-form pricing formula or an efficient simulation method. Furthermore, “unified” indicates the importance of integrating empirical and theoretical results in term-structure modeling for cross-asset markets such as with interest-rate futures and commodity futures. Also, “unified” implies the flexibility of integrating various trading strategies and the novelty of bridging the complete and incomplete market assumptions.

Key words: Unified Paradigm; interest-rate model; bond model; risk management; derivatives pricing framework

JEL codes: G12, G13