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On the relevance of modeling volatility for pricing purposes

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  • Manuel Moreno

Abstract

This paper presents a two-factor (Vasicek-CIR) model of the term structure of interest rates and develops its pricing and empirical properties. We assume that default free discount bond prices are determined by the time to maturity and two factors, the long-term interest rate and the spread. Assuming a certain process for both factors, a general bond pricing equation is derived and a closed-form expression for bond prices is obtained. Empirical evidence of the model's performance in comparisson with a double Vasicek model is presented. The main conclusion is that the modeling of the volatility in the long- term rate process can help (in a large amount) to fit the observed data can improve - in a reasonable quantity - the prediction of the future movements in the medium- and long-term interest rates. However, for shorter maturities, it is shown that the pricing errors are, basically, negligible and it is not so clear which is the best model to be used.

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Bibliographic Info

Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 431.

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Date of creation: Sep 1997
Date of revision: Oct 1999
Handle: RePEc:upf:upfgen:431

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Web page: http://www.econ.upf.edu/

Related research

Keywords: Term structure of interest rates; bond pricing equation; two-factor models; Ornstein-Uhlenbeck process; CIR process;

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