In interest rate models, the option price is typically valuated under the riskneutral measure, and so these models have been developed as models specified under the risk-neutral measure.
On the one hand, when we apply a model to risk management, we must use a model specified under the real-world measure. We consider this further by valuating the VaR of a simple example. On the other hand, to construct an interest rate model under the real-world measure, it is necessary to estimate the market price of risk. We briefly summarize some approaches to estimation of that price in the short rate models.
Total Pages: 65-90 (26)
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