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Pricing Interest Rate Derivatives in a Non-Parametric Two-Factor Term-Structure Model

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Author Info

  • Knight, John
  • Li, Fuchun
  • Yuan, Mingwei

Abstract

Diffusion functions in term-structure models are measures of uncertainty about future price movements and are directly related to the risk associated with holding financial securities. Correct specification of diffusion functions is crucial in pricing options and other derivative securities. In contrast to the standard parametric two-factor models, we propose a non-parametric two-factor term-structure model that imposes no restrictions on the functional forms of the diffusion functions. Hence, this model allows for maximum flexibility when fitting diffusion functions into data. A non-parametric procedure is developed for estimating the diffusion functions, based on the discretely sampled observations. The convergence properties and the asymptotic distributions of the proposed non-parametric estimators of the diffusion functions with multivariate dimensions are also obtained. Based on U.S. data, the non-parametric prices of the bonds and bond options are computed and compared with those calculated under an alternative parametric model. The empirical results show that the non-parametric model generates significantly different prices for the derivative securities.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 99-19.

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Length: 55 pages
Date of creation: 1999
Date of revision:
Handle: RePEc:bca:bocawp:99-19

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Keywords: Econometric and statistical methods; Market structure and pricing;

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Cited by:
  1. Lange, Ron, 1999. "The Expectations Hypothesis for the Longer End of the Term Structure: Some Evidence for Canada," Working Papers 99-20, Bank of Canada.
  2. Adam Canopius, 2006. "Practitioners' Corner," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 4(2), pages 346-351.
  3. Andrew Jeffrey, 2004. "Nonparametric Estimation of a Multifactor Heath-Jarrow-Morton Model: An Integrated Approach," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 2(2), pages 251-289.
  4. Adland, Roar & Jia, Haiying & Lu, Jing, 2008. "Price dynamics in the market for Liquid Petroleum Gas transport," Energy Economics, Elsevier, vol. 30(3), pages 818-828, May.
  5. Andrew Jeffrey & Linton, Oliver Linton & Thong Nguyen & Peter C.B. Phillips, 2001. "Nonparametric Estimation of a Multifactor Heath-Jarrow-Morton Model: An Integrated Approach," Cowles Foundation Discussion Papers 1311, Cowles Foundation for Research in Economics, Yale University.
  6. John Knight & Fuchun Li & Mingwei Yuan, 2006. "A Semiparametric Two-Factor Term Structure Model," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 4(2), pages 204-237.

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