Chapter 31
Interest Rate Models
31.1 CHAPTER SUMMARY
This chapter integrates the option pricing part of the book with the interest rate part of the book. The introductory Section 31.2 considers a bond to be a derivative on the spot interest rate, albeit a derivative for which the underlying cannot be hedged, a partial differential equation for the price of a zero coupon bond is developed. This requires some thinking about how to hedge when you cannot trade the underlying—this is done by hedging against another bond. A binomial tree model in Section 31.3 sets the stage for the resulting “market price of risk” discussion. With that in hand, a PDE can be developed for the price of a zero coupon bond, if the spot rate of interest follows a general ...
Get Quantitative Finance now with the O’Reilly learning platform.
O’Reilly members experience books, live events, courses curated by job role, and more from O’Reilly and nearly 200 top publishers.
