Abstract and Applied Analysis

Abstract and Applied Analysis / 2013 / Article
Special Issue

Nonlinear Functional Analysis of Boundary Value Problems 2013

View this Special Issue

Research Article | Open Access

Volume 2013 |Article ID 857678 | 8 pages | https://doi.org/10.1155/2013/857678

A Stochastic String with a Compound Poisson Process

Academic Editor: Shaoyong Lai
Received28 May 2013
Accepted10 Jul 2013
Published01 Aug 2013


We investigate a compound Poisson infinite factor diffusion model which describes the relationship between the infinite-dimension random risk resource and the corresponding stochastic process. We derive the no-arbitrage condition on the drift of instantaneous forward rates in the compound model and study the impact of random jump on the price of the zero-coupon bond.

1. Introduction

In the study of the stochastic process, the expansion from single-factor model to multiple-factor model greatly improves its capability to describe the dynamic properties. For the term structure of interest rates, multiple-factor expansion enables itself to more flexibly describe the relationship between different maturities and their corresponding risk-free interest rates. The term structure curve contains rich information about the economy status and financial markets. The literatures have witted extensive researches on this topic for recent decades. For instance, the HJM model in [1, 2] provides insight about arbitrage-free condition of the shift and volatility of the dynamic process of forward interest rates under the risk-free condition. Kennedy [3, 4], Goldstein [5], and Santa-Clara and Didier [6] model each time-to-maturity forward rate driven by its own shock termed Brown Sheet, Random Field, or Stochastic String. In fact, the models in [36] expand the multiple-factor model to infinite stochastic factor with imperfect correlation among different maturities. At the same time, the correlations are not confined by the function form of volatilities. These results display greater variability in the correlation between different maturities.

In this paper, according to the stochastic string model presented in [6], we introduce a compound Poisson process with a constant jump intensity and random jump size to capture information burst and resulting discontinuous path. We derive the no-arbitrage condition in the compound Poisson infinite-dimensional diffusion process in which the drift and volatility of stochastic process under the risk-neutral measure are satisfied. Some of the results in [6] are extended.

The paper is organized as follows. Section 2 reviews the single-factor, multiple-factor model and stochastic string model, which are related to our study. In Section 3, we add a random jump process in the stochastic string model discussed in [6] and analyze its dynamic properties. An application of our main result is presented in Section 4.

2. Single-Factor, Multiple-Factor Model and Stochastic String Model

For a probability space , the dynamics of a stochastic process is described by where is a standard Wiener process and and are drift and volatility terms, respectively. When is explained as the instantaneous forward rate at time for time-to-maturity , (1) is the HJM model. The price at time of a bond with maturity is The HJM model has no-arbitrage condition which is written by where the process denotes the market price of risk at time . Using Itô’s formula, we calculate the dynamics of bond prices as Under the no-arbitrage condition, the instantaneous forward rate of time-to-maturity is where In fact, every term structure model driven by Brownian motion is a special case of the HJM model (e.g., the Vasicek model in [7], the Hull-White model in [8], etc.). However, the single-factor HJM model has a limitation that different time-to-maturities are completely correlated; that is, their correlation coefficient equals 1. This implies that(1)the term structure curve would parallel shift which limits its capability to generate richer class of dynamics and shapes of the term structure of interest rates,(2)it does not permit consistency with term structure innovation along with the time.

One way to extend the model is by introducing the -dimensional Brownian motion to the term structure model written by One can obtain the correlation of the forward rate curve driven by the -dimensional Brownian motion as Different from the multiple-factor HJM model in (7), which implies all assets shocked by the common factors, Santa-Clara and Didier [6] model the forward rate as a stochastic string and allow each forward rate to be driven by its own random risk resource.

Assume that the dynamics of the instantaneous forward rates at with time-to-maturity is modeled by where is a generalization of Brownian motion which depends on both time and time-to-maturity . The notation means that the increment is taken with respect to time . Equation (9) is not the infinite-dimensional simple generalization of the multifactor HJM model, in which all forward rates are subject to the same (possibly infinite) set of Brownian motion shocks. In this model, there is one different stochastic shock for each time-to-maturity. Given time-to-maturity , the stochastic perturbation is a standard Wiener process, which satisfies several requirements (see [6] for details). For example, the correlation coefficient matrix is positive semidefinite, which means that, for all functions in and for some large enough constant , The no-arbitrage condition of the drift of instantaneous forward rate is The solution of the stochastic differential equation for instantaneous forward interest rate is where Under the arbitrage-free condition, we have where The covariance of different time-to-maturity zero-coupon bond yields is

3. Compound Poisson Infinite-Dimensional Diffusion Process

Information burst, some emergency events, crises, and monetary target adjustment may cause the return and price of asset jump. There are more and more empirical lines of evidence which show that the interest rate models should incorporate the jump risk. The difference of the asset price of continuous path will disappear as the change of time converges to zero. We know that in the jump model, the difference does not converge to zero, although its probability of jump occurrence will converge to 0. Eberlein et al. [9] investigate the term structure models driven by Lévy processes.

Based on the continuous path of instantaneous forward rate used in Santa-Clara and Didier [6] and other works [35], we introduce a compound Poisson process to capture the yield curve jump. For each time-to-maturity , assume that the dynamics of instantaneous forward rate is where is a compound Poisson process and . Poisson process counts the number of jumps that occur at or before time . are independent identically distributed discrete random variables with finite values , with probability , . is a nonrandom function. The compound jump is independent of the stochastic string .

Applying the decomposition theorem of a compound Poisson process (see [10]), may be rewritten as . So, we can rewrite the dynamics of instantaneous forward rates as where is the same random risk resource as defined in (9).

Assume that the market is complete, so that the existence and uniqueness of the risk market price are guaranteed. It can be proved that the continuous part of random risk factor is independent of the jump risk factor.

For the continuous risk resource part, define or in differential form The correlation coefficient for different time-to-maturity random risk resource is the same as that of . For fixed time-to-maturity , let We obtain the risk-neutral measure under some conditions. Using the properties of risk-neutral measure , for fixed time-to-maturity , we know that is a martingale. At the same time, is a compound Poisson process with intensity . The jump sizes are still I.I.D. random variables, while the jump intensity satisfies for arbitrary , where and each is a positive constant. Notice that, under the new measure , is still independent of , .

Theorem 1. If the market is complete, the arbitrage-free condition of the instantaneous forward rate satisfies

Proof. The price at time of a zero-coupon bond with maturity is . For fixed , we have Differentiating with respect to time in (23), we obtain Applying jump process Itô’s formula (see [10]), we have Under the risk-neutral probability measure , the price of zero-coupon bond satisfies Combining (25) with (26), we have which is the expression that the risk market prices satisfy. It includes market prices of jump risk factors and infinite random risk resource. Note that the compensated Poisson process in (26) is a martingale. Let , and applying the stochastic Fubini theorem, we rewrite (27) as Differentiating (28) with respect to , we obtain Rearranging (29), we obtain the arbitrage-free condition of (22). It completes the proof.

Remark 2. When , (22) reduces to which is the arbitrage-free condition presented in [6]. Moreover, for arbitrary time-to-maturity and , if , and let , then the arbitrage-free condition becomes which is the arbitrage-free condition of the one-dimensional HJM model.
Under the risk-neutral measure , the dynamics of instantaneous forward rates which satisfy the arbitrage-free condition can be rewritten as where

Theorem 3. Under the risk-neutral measure , the price at time of a zero-coupon bond with maturity is

Proof. We show that (34) is the solution of (26). Obviously, when , the result is correct. Let , where Denote Then, we have Notice that as the length of time interval converges to 0, there is at most one jump in each time interval. Combining (37) with (38), we obtain Therefore, (34) is the solution of (26). It completes the proof.

Remark 4. In (34), it shows that the price of zero-coupon bond is affected by two parts: continuous component and jump component. For the continuous part, besides the risk-free interest rate effect, the stochastic string risk resources till to the maturity would generate an accumulated effect on the price of zero-coupon bond. As the occurrence of jump, its long-term accumulative effects will be offset by part of . The correlation of different maturities from time to maturity has an explicit effect on the price. For the jump component, the effect is scaled by the function , which captures the jump effect on the financial variables.

4. Application

The compound Poisson infinite diffusion model developed in Section 3 comprises the traditional jump-diffusion model. We consider that the jump sizes are discrete random variables. It is convenient to introduce the continuous jump size model whose size is, for instance, normally distributed random variable.

We consider the price of the short-term interest rate futures. Assume that the financial market is shocked by two kinds of random risk resource: one is continuous risk factor of and the other is a compound Poisson process. Assume that the market is complete. Consider a futures contract maturity at , , whose underlying asset is the zero-coupon bond maturity at . Denote the futures price at time as . Under the risk-neutral measure , the futures price is a martingale. We have

Theorem 5. Under the risk-neutral measure , the futures price with underlying asset as a zero-coupon bond is

Proof. Note that the zero-coupon bond price is a function of instantaneous forward rates Therefore, we have Applying the stochastic Fubini theorem and exchanging the integral order, we obtain Therefore, it has Taking out what is known, we obtain Applying independent theorem in [10], we have where the first conditional expectation is The conditional expectation of the increments of jump process is Thus, the price of futures is Rearranging (50), we obtain the futures price expressed as (41). It completes the proof.


Thanks are due to the referees whose meaningful suggestions are very helpful to revise the paper. This work is supported by the Fundamental Research Funds for the Central Universities (JBK130401).


  1. D. C. Heath, R. A. Jarrow, and A. Morton, “Bond pricing and the term structure of interest rates: a discrete time approximitation,” Journal of Financial and Quantitative Analysis, vol. 25, no. 4, pp. 419–440, 1990. View at: Google Scholar
  2. D. C. Heath, R. A. Jarrow, and A. Morton, “Bond pricing and the term structure of interest rates: a new methodology for contingent claims valuation,” Econometrica, vol. 60, no. 60, pp. 77–105, 1992. View at: Google Scholar
  3. D. P. Kennedy, “The term structure of interest rates as a Gaussian random field,” Mathematical Finance, vol. 4, no. 3, pp. 247–258, 1994. View at: Publisher Site | Google Scholar | Zentralblatt MATH | MathSciNet
  4. D. P. Kennedy, “Characterizing Gaussian models of the term structure of interest rates,” Mathemnatical Finance, vol. 7, no. 2, pp. 107–118, 1997. View at: Google Scholar
  5. R. S. Goldstein, “The term structure of interest rates as a random field,” The Review of Financial Studies, vol. 13, no. 2, pp. 365–384, 2000. View at: Google Scholar
  6. P. Santa-Clara and S. Didier, “The dynamics of the forward interest rate curve with stochastic string shocks,” The Review of Financial Studies, vol. 14, no. 1, pp. 149–185, 2001. View at: Google Scholar
  7. O. Vasicek, “An equilibrium characterization of the term structure,” Journal of Financial Economics, vol. 5, pp. 177–188, 1977. View at: Google Scholar
  8. J. Hull and A. White, “Pricing interest rate derivative securities,” The Review of Financial Studies, vol. 3, no. 4, pp. 573–592, 1990. View at: Google Scholar
  9. E. Eberlein, J. Jacod, and S. Raible, “Lévy term structure models: no-arbitrage and completeness,” Finance and Stochastics, vol. 9, no. 1, pp. 67–88, 2005. View at: Publisher Site | Google Scholar | MathSciNet
  10. S. E. Shreve, Stochastic Calculus for Finance II: Continuous-Time Models, Springer, New York, NY, US, 2004. View at: MathSciNet

Copyright © 2013 Sheng Fan. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

868 Views | 476 Downloads | 1 Citation
 PDF  Download Citation  Citation
 Download other formatsMore
 Order printed copiesOrder