A FILTERING APPROACH TO PRICING IN MULTIFACTOR TERM STRUCTURE MODELS

We present an approach for the pricing of illiquid bonds (and bond derivatives) in an arbitrage-free way and which is consistent with the observed prices of liquid bonds. The basic model is a multifactor term structure model with abstract latent factors. The approach is based on stochastic filtering techniques, leading to a continuous update of the distribution of the latent factors on the basis of the information coming from the observations. This allows our model to continuously "track" the real market.