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Nonparametric Modeling of U.S. Interest Rate Term Structure Dynamics and Implications on the Prices of Derivative Securities

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  • Jiang, George J.

Abstract

This paper develops a nonparametric model of interest rate term structure dynamics based on a spot rate process that permits only positive interest rates and a market price of interest rate risk that precludes arbitrage opportunities. Both the spot rate process and the market price of interest rate risk are nonparametrically specified so that the model allows for maximal flexibility in fitting into the data. Marginal density of interest rates and historical term structure data are exploited to provide robust estimation of the nonparametric term structure model. The model is implemented using U.S. data, and the estimation results are compared to those in the available literature. Empirical results not only provide strong evidence that most traditional spot rate models and market prices of interest rate risk are misspecified, but also confirm that the nonparametric model generates significantly different term structures and prices of common derivatives.

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  • Jiang, George J., 1998. "Nonparametric Modeling of U.S. Interest Rate Term Structure Dynamics and Implications on the Prices of Derivative Securities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(04), pages 465-497, December.
  • Handle: RePEc:cup:jfinqa:v:33:y:1998:i:04:p:465-497_00
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    1. De Schepper, A. & Teunen, M. & Goovaerts, M., 1994. "An analytical inversion of a Laplace transform related to annuities certain," Insurance: Mathematics and Economics, Elsevier, vol. 14(1), pages 33-37, April.
    2. J. A. Nielsen & K. Sandmann, 1996. "The pricing of Asian options under stochastic interest rates," Applied Mathematical Finance, Taylor & Francis Journals, vol. 3(3), pages 209-236.
    3. Alziary, Benedicte & Decamps, Jean-Paul & Koehl, Pierre-Francois, 1997. "A P.D.E. approach to Asian options: analytical and numerical evidence," Journal of Banking & Finance, Elsevier, vol. 21(5), pages 613-640, May.
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