Market Price of Risk in the 2FBK Model: A General Specification
Document ID: 2007-13 (previously 2007/005)
Published on: 1st July 2007
Author: Steven Morrison
This note describes the change of measure between the 'risk-neutral' and 'real world' probability measures, in the 2-factor Black-Karasinski (2FBK) interest-rate model. In the current B&H implementation of this model we describe this change of measure by a single 'market price of risk' parameter, common to both interest-rate factors. This is a special case of a more general specification, in which we have a separate market-price of risk for each factor. In general these market-prices of risk may depend on time (and/or the state variables of the model). This note describes this more general specification of the model and demonstrates the additional calibration freedom that is introduced by this generalisation.
