Bond pricing formulas for Markov-modulated affine term structure models

Authors

Marianito R. Rodrigo, University of WollongongFollow
Rogemar S. Mamon

RIS ID

144094

Publication Details

Rodrigo, M. R. & Mamon, R. S. (2020). Bond pricing formulas for Markov-modulated affine term structure models. Journal of Industrial and Management Optimization, Online First 1-18.

Abstract

This article provides new developments in characterizing the class of regime-switching exponential affine interest rate processes in the context of pricing a zero-coupon bond. A finite-state Markov chain in continuous time dictates the random switching of time-dependent parameters of such processes. We present exact and approximate bond pricing formulas by solving a system of partial differential equations and minimizing an error functional. The bond price expression exhibits a representation that shows how it is explicitly impacted by the rate matrix and the time-dependent coefficient functions of the short rate models. We validate the bond pricing formulas numerically by examining a regime-switching Vasicek model.