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Randomised Mixture Models for Pricing Kernels

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  • Andrea Macrina
  • Priyanka A. Parbhoo

Abstract

Numerous kinds of uncertainties may affect an economy, e.g. economic, political, and environmental ones. We model the aggregate impact by the uncertainties on an economy and its associated financial market by randomised mixtures of L\'evy processes. We assume that market participants observe the randomised mixtures only through best estimates based on noisy market information. The concept of incomplete information introduces an element of stochastic filtering theory in constructing what we term "filtered Esscher martingales". We make use of this family of martingales to develop pricing kernel models. Examples of bond price models are examined, and we show that the choice of the random mixture has a significant effect on the model dynamics and the types of movements observed in the associated yield curves. Parameter sensitivity is analysed and option price processes are derived. We extend the class of pricing kernel models by considering a weighted heat kernel approach, and develop models driven by mixtures of Markov processes.

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  • Andrea Macrina & Priyanka A. Parbhoo, 2011. "Randomised Mixture Models for Pricing Kernels," Papers 1112.2059, arXiv.org.
    • Handle: RePEc:arx:papers:1112.2059
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    References listed on IDEAS

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    2. Jirô Akahori & Andrea Macrina, 2022. "Heat Kernel Interest Rate Models With Time-Inhomogeneous Markov Processes," World Scientific Book Chapters, in: Dorje Brody & Lane Hughston & Andrea Macrina (ed.), Financial Informatics An Information-Based Approach to Asset Pricing, chapter 9, pages 179-193, World Scientific Publishing Co. Pte. Ltd..
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    4. Damir Filipović & Lane P. Hughston & Andrea Macrina, 2012. "Conditional Density Models For Asset Pricing," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 15(01), pages 1-24.
    5. Jiro Akahori & Yuji Hishida & Josef Teichmann & Takahiro Tsuchiya, 2009. "A Heat Kernel Approach to Interest Rate Models," Papers 0910.5033, arXiv.org.
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    9. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305, World Scientific Publishing Co. Pte. Ltd..
    10. Damir Filipović & Lane P. Hughston & Andrea Macrina, 2012. "Conditional Density Models For Asset Pricing," World Scientific Book Chapters, in: Matheus R Grasselli & Lane P Hughston (ed.), Finance at Fields, chapter 9, pages 225-248, World Scientific Publishing Co. Pte. Ltd..
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