Jackknifing Bond Option Prices
AbstractIn continuous time specifications, the prices of interest rate derivative securities depend crucially on the mean reversion parameter of the associated interest rate diffusion equation. This parameter is well known to be subject to estimation bias when standard methods like maximum likelihood (ML) are used. The estimation bias can be substantial even in very large samples and it translates into a bias in pricing bond options and other derivative securities that is important in practical work. The present paper proposes a very general method of bias reduction for pricing bond options that is based on Quenouille's (1956) jackknife. We show how the method can be applied directly to the options price itself as well as the coefficients in continuous time models. The method is implemented and evaluated here in the Cox, Ingersoll and Ross (1985) model, although it has much wider applicability. A Monte Carlo study shows that the proposed procedure achieves substantial bias reductions in pricing bond options with only mild increases in variance that do not compromise the overall gains in mean squared error. Our findings indicate that bias correction in estimation of the drift can be more important in pricing bond options than correct specification of the diffusion. Thus, even if ML or approximate ML can be used to estimate more complicated models, it still appears to be of equal or greater importance to correct for the effects on pricing bond options of bias in the estimation of the drift. An empirical application to U.S. interest rates highlights the differences between bond and option prices implied by the jackknife procedure and those implied by the standard approach. These differences are large and suggest that bias reduction in pricing options is important in practical applications.
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Bibliographic InfoPaper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1392.
Length: 51 pages
Date of creation: Jan 2003
Date of revision:
Publication status: Published in Review of Financial Studies (2005), 18(2): 707-742
Note: CFP 1119.
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA
Other versions of this item:
- Jun Yu & Peter Phillips, 2004. "Jackknifing Bond Option Prices," Econometric Society 2004 North American Winter Meetings 115, Econometric Society.
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models &bull Diffusion Processes
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2003-02-03 (All new papers)
- NEP-CFN-2003-02-03 (Corporate Finance)
- NEP-CMP-2003-02-03 (Computational Economics)
- NEP-ECM-2003-02-10 (Econometrics)
- NEP-FMK-2003-02-03 (Financial Markets)
- NEP-RMG-2003-02-03 (Risk Management)
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