COHERENT CHAOS INTEREST-RATE MODELS

Abstract

The Wiener chaos approach to interest-rate modeling arises from the observation that in the general context of an arbitrage-free model with a Brownian filtration, the pricing kernel admits a representation in terms of the conditional variance of a square-integrable generator, which in turn admits a chaos expansion. When the expansion coefficients of the random generator factorize into multiple copies of a single function, the resulting interest-rate model is called "coherent", whereas a generic interest-rate model is necessarily "incoherent". Coherent representations are of fundamental importance because an incoherent generator can always be expressed as a linear superposition of coherent elements. This property is exploited to derive general expressions for the pricing kernel and the associated bond price and short rate processes in the case of a generic nth order chaos model, for each n ∈ ℕ. Pricing formulae for bond options and swaptions are obtained in closed form for a number of examples. An explicit representation for the pricing kernel of a generic incoherent model is then obtained by use of the underlying coherent elements. Finally, finite-dimensional realizations of coherent chaos models are investigated and we show that a class of highly tractable models can be constructed having the characteristic feature that the discount bond price is given by a piecewise-flat (simple) process.