Concept

Short-rate model

Summary
A short-rate model, in the context of interest rate derivatives, is a mathematical model that describes the future evolution of interest rates by describing the future evolution of the short rate, usually written r_t ,. The short rate Under a short rate model, the stochastic state variable is taken to be the instantaneous spot rate. The short rate, r_t ,, then, is the (continuously compounded, annualized) interest rate at which an entity can borrow money for an infinitesimally short period of time from time t. Specifying the current short rate does not specify the entire yield curve. However, no-arbitrage arguments show that, under some fairly relaxed technical conditions, if we model the evolution of r_t , as a stochastic process under a risk-neutral measure Q, then the price at time t of a zero-coupon bond maturing at time T with a payoff of 1 is given by : P(t,T) = \operat
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