The Potential Approach to Bond and Currency Pricing

37 Pages Posted: 17 Apr 1999

See all articles by Markus Leippold

Markus Leippold

University of Zurich - Department of Banking and Finance; University of Zurich - Faculty of Economics, Business Administration and Information Technology

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Date Written: March 8, 1999

Abstract

The pricing kernel, or the state-price density, which relates future cash flows to today's price, is the fundamental building block of modern asset pricing theory. In abstract, the state-price density process can be regarded as a positive supermartingale, or, under some regularity conditions, a potential. The theory of Markov processes provides a rich framework for the generation of examples of potentials. In this paper, we begin the modeling of bond and currency prices from the modeling of the state-price density satisfying basic properties of a potential. We provide extensive examples on the potential modeling of the state-price densities and their implications on bond and currency pricing. We show that most classic interest rate models are special cases of this general approach. We also investigate the connection between the potential approach and the Heath, Jarrow, and Morton approach widely used in the finance area. One advantage of the potential approach resides in its great ease in modeling the yield curves of many countries at the same time, together with the exchange rates between them. We derive the properties of exchange rates under each example and illustrate their possibility in explaining the forward premium puzzle.

JEL Classification: G12, G13, G15, E43, C60

Suggested Citation

Leippold, Markus and Wu, Liuren, The Potential Approach to Bond and Currency Pricing (March 8, 1999). Available at SSRN: https://ssrn.com/abstract=155430 or http://dx.doi.org/10.2139/ssrn.155430

Markus Leippold (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

University of Zurich - Faculty of Economics, Business Administration and Information Technology ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

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