A pure-jump mean-reverting short rate model

TL;DR

This paper introduces a new multi-factor pure-jump mean-reverting short rate model with affine bond prices, providing explicit pricing formulas and calibration conditions, suitable for practical financial applications and post-crisis adjustments.

Contribution

It presents a novel bounded multi-factor pure-jump short rate model with affine bond prices and explicit option pricing formulas, extending to post-crisis scenarios.

Findings

Model ensures bounded short rates with affine bond prices.

Explicit formula for vanilla option pricing derived.

Calibration conditions for market consistency established.

Abstract

A new multi-factor short rate model is presented which is bounded from below by a real-valued function of time. The mean-reverting short rate process is modeled by a sum of pure-jump Ornstein--Uhlenbeck processes such that the related bond prices possess affine representations. Also the dynamics of the associated instantaneous forward rate is provided and a condition is derived under which the model can be market-consistently calibrated. The analytical tractability of this model is illustrated by the derivation of an explicit plain vanilla option price formula. With view on practical applications, suitable probability distributions are proposed for the driving jump processes. The paper is concluded by presenting a post-crisis extension of the proposed short and forward rate model.