The potential approach in practice

TL;DR

This paper explores the practical application of the potential approach for modeling financial assets like interest rates and foreign exchange rates, using liquid derivatives data and finite-state Markov chains.

Contribution

It demonstrates how to fit potential models to real financial data employing a finite-state Markov process, bridging theory and practice.

Findings

Successful fitting of potential models to interest rate derivatives data

Validation of the potential approach's applicability in practical settings

Potential models effectively capture dynamics of financial assets

Abstract

The potential approach is a general and simple method for modelling interest rates, foreign exchange rates, and in principle other types of financial assets. This paper takes data on some liquid interest rate derivatives, and fits potential models using a small finite-state Markov chain as the base Markov process.