On pricing of interest rate derivatives

TL;DR

This paper discusses the limitations of traditional interest rate derivative pricing methods by highlighting the leptokurtic nature of IR processes and proposes a martingale pricing scheme to better capture this behavior.

Contribution

It introduces a martingale pricing framework that accounts for leptokurticity in interest rate models, addressing a gap in existing textbook methods.

Findings

Leptokurtic behavior observed in LIBOR data

Traditional models fail to capture leptokurticity

Proposed martingale scheme better fits observed data

Abstract

At present, there is an explosion of practical interest in the pricing of interest rate (IR) derivatives. Textbook pricing methods do not take into account the leptokurticity of the underlying IR process. In this paper, such a leptokurtic behaviour is illustrated using LIBOR data, and a possible martingale pricing scheme is discussed.