The Q-Measure Dynamics of Forward Rates

Abstract

I review how the theoretical modeling of the dynamics of forward rates in the context of derivatives pricing has evolved over time. I review the theoretical developments from the short rate models of the 1980s to the stochastic-volatility extensions of the SABR model. I argue that how the theory developed can be understood only by taking into account the institutional setting of derivatives trading and that the modeling choices were motivated to a surprisingly large extent by how the market evolved. I conclude with an assessment of which of these theoretical contributions have had a lasting and meaningful effect on the financial theory of asset pricing. Expected final online publication date for the Annual Review of Financial Economics, Volume 15 is November 2023. Please see http://www.annualreviews.org/page/journal/pubdates for revised estimates.