A deterministic–shift extension of analytically–tractable and time–homogeneous short–rate models

Abstract.

In the present paper we show how to extend any time-homogeneous short-rate model to a model that can reproduce any observed yield curve, through a procedure that preserves the possible analytical tractability of the original model. In the case of the Vasicek (1977) model, our extension is equivalent to that of Hull and White (1990), whereas in the case of the Cox-Ingersoll-Ross (1985) (CIR) model, our extension is more analytically tractable and avoids problems concerning the use of numerical solutions. We also consider the extension of time-homogeneous models without analytical formulas. We then explain why the CIR model is the most interesting model to be extended through our procedure, analyzing it in detail. We also consider an example of calibration to the cap market for two of the presented models. We finally hint at the same extension for multifactor models and explain its advantages for applications.