Information of Interest
Dorje C. Brody, Robyn L. Friedman (Imperial College London)
TL;DR
This paper introduces an information-based model for discount bond pricing that incorporates market perceptions of future liquidity risk, deriving formulas for bond and interest rate derivative prices.
Contribution
It presents a novel liquidity-based bond pricing model and derives explicit formulas for bond and interest rate derivative prices.
Findings
Bond volatility depends on weighted perpetual annuities.
Derived explicit pricing formulas for interest rate derivatives.
Model links market liquidity perception to bond price dynamics.
Abstract
A pricing formula for discount bonds, based on the consideration of the market perception of future liquidity risk, is established. An information-based model for liquidity is then introduced, which is used to obtain an expression for the bond price. Analysis of the bond price dynamics shows that the bond volatility is determined by prices of certain weighted perpetual annuities. Pricing formulae for interest rate derivatives are derived.
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