Common Forward Rate Volatility

Statistical analyses of forward interest rate behavior provide evidence that these rates share a common volatility. We develop a risk-neutral term structure model based on this assumption. The main feature of this model is that each discounted bond price is both an explicit local martingale and a diffusion. The Markov property of discounted bonds is convenient for pricing interest rate derivatives. We give price formulas for caps and swaptions and compare caplet prices to the market-standard Black formula. The two formulas have nearly identical numerical values