The Potential Approach to the Term Structure of Interest Rates and Foreign Exchange Rates

It is possible to specify a model for interest rates in various ways, by giving the dynamics of the spot rate or of the forward rates, for example. A less well-developed approach is to specify the law of the state-price density process directly. In abstract, the state-price density process is a positive supermartingale, and the theory of Markov processes provides a rich framework for the generation of examples of such things. We show how this can be done, and provide simple examples (some familiar, some new) where prices of derivatives can be computed very easily. One benefit of the potential approach is that it becomes very easy to model the yield curve in many countries at once, together with the exchange rates between them. Copyright Blackwell Publishers Inc. 1997.