Self exciting threshold interest rates models.

Abstract

In this paper, we study a new class of tractable diffusions suitable for model's primitives of interest rates. We consider scalar diffusions with scale s'(x) and speed m(x) densities discontinuous at the level x*. We call that family of processes Self Exciting Threshold (SET) diffusions. Following Gorovoi and Linetsky (2004), we obtain semianalytical expressions for the transition density of SET (killed) diffusions. We propose several applications to interest rates modeling. We show that SET short rate processes do not generate arbitrage possibilities and we adapt the HJM procedure to forward rates with discontinuous scale density. We also extend the CEV and the shiftedlognormal Libor market models. Finally, the models are calibrated to the U.S. market. SET diffusions can also be used to model stock price, stochastic volatility, credit spread, etc.Eigenfunction expansions; Interest rates; Market models; SETAR; Skew Brownian motion; State-price density;