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The Potential Approach In Practice

Author

Listed:
  • T. KLUGE

    (Statistical Laboratory, University of Cambridge, Wilberforce Road, Cambridge CB3 0WB, UK)

  • L. C. G. ROGERS

    (Statistical Laboratory, University of Cambridge, Wilberforce Road, Cambridge CB3 0WB, UK)

Abstract

This paper studies the fitting of Markov chain potential models to interest-rate derivative prices in four currencies simultaneously, using sequential Monte Carlo methodology (particle filtering). The potential approach starts from some Markov process which is supposed to drive the random observations, and there have been many studies where this Markov process is taken to be a diffusion; fewer studies have worked from a finite-state Markov chain, and this seems to be the first study to attempt to fit such models to data. With the available data, we show impressive agreement of the fitted models with market prices.

Suggested Citation

  • T. Kluge & L. C. G. Rogers, 2018. "The Potential Approach In Practice," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(03), pages 1-30, May.
    • Handle: RePEc:wsi:ijtafx:v:21:y:2018:i:03:n:s0219024918500218
    DOI: 10.1142/S0219024918500218
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    References listed on IDEAS

    as
    1. Naosuke Nakamura & Fan Yu, 2000. "Interest Rate, Currency and Equity Derivatives Valuation Using the Potential Approach," International Review of Finance, International Review of Finance Ltd., vol. 1(4), pages 269-294, December.
    2. L. C. G. Rogers, 1997. "The Potential Approach to the Term Structure of Interest Rates and Foreign Exchange Rates," Mathematical Finance, Wiley Blackwell, vol. 7(2), pages 157-176, April.
    3. Damir Filipović & Martin Larsson & Anders B. Trolle, 2017. "Linear-Rational Term Structure Models," Journal of Finance, American Finance Association, vol. 72(2), pages 655-704, April.
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