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An interest rate model with a Markovian mean reverting level

By Robert Elliott and Rogemar Mamon

Abstract

A two-factor Vasicek model, where the mean reversion level changes according to a continuous time finite state Markov chain, is considered. This model could capture the behaviour of monetary authorities who normally set a reference rate which changes from time to time. We derive the term structure via the analytic expression of the bond price that involves a fundamental matrix. The validity of the bond price closed form solution is verified via the forward rate dynamics.

DOI identifier: 10.1080/14697688.2002.0000012
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