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Markovian Quadratic Term Structure Models For Risk-free And Defaultable Rates

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Author Info
Li Chen (Princeton University)
H. Vincent Poor (Princeton University)

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Abstract

In this paper, a class of regular quadratic Gaussian processes is defined to characterize quadratic term structure models (QTSMs) in a general Markovian setting. The primary motivation for this definition is to provide a more general model for the quadratic term structure of the forward curve, while maintaining the analytical tractability of the traditional QTSMs. It is demonstrated that the tractability of QTSMs does not necessarily rely on the Ornstein-Uhlenbeck state processes used in their traditional definition. Rather, the crucial element that provides analytical solutions for the prices of zero-coupon bonds and their options is a so-called quadratic Gaussian property as defined in this paper. In order to retain this property for a general Markov process, it is shown that, under the regularity conditions, no jumps are allowed in the infinitesimal generator of the process. It is further shown that the coefficient functions defined in the quadratic Gaussian property can be determined by multi-variate Riccati equations with a unique admissible parameter set. The implications of this result for modeling the term structure of risk-free rates and defaultable rates are discussed.

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Paper provided by EconWPA in its series Finance with number 0303008.

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Length: 20 pages
Date of creation: 31 Mar 2003
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Handle: RePEc:wpa:wuwpfi:0303008

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Related research
Keywords: Quadratic term structure models option pricing defaultable rates time-homogenous Markov processes

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Find related papers by JEL classification:
C39 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Other

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Markus Leippold & Liuren Wu, 2002. "Asset Pricing Under The Quadratic Class," Finance 0207015, EconWPA. [Downloadable!]
  2. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 12(4), pages 687-720.
  3. Markus Leippold & Liuren Wu, 2002. "Design and Estimation of Quadratic Term Structure Models," Finance 0207014, EconWPA. [Downloadable!]
  4. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
  5. Dong-Hyun Ahn & Robert F. Dittmar, 2002. "Quadratic Term Structure Models: Theory and Evidence," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 15(1), pages 243-288, March.
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Li Chen & Damir Filipovic, 2003. "Modeling Credit Risk by Affine Processes," Finance 0303006, EconWPA. [Downloadable!]
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