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A simple regime switching term structure model

  • Asbjørn T. Hansen

    (Global Equities, Dresdner Kleinwort Benson, 20 Fenchurch Street, London EC3P 3DB, UK)

  • Rolf Poulsen

    (Department of Statistics and Operations Research, University of Copenhagen, Universitetsparken 5, DK-2100, Denmark Manuscript)

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    We extend the short rate model of Vasicek (1977) to include jumps in the local mean. Conditions ensuring existence of a unique equivalent martingale measure are given, implying that the model is arbitrage-free and complete. We develop efficient numerical methods for computation of zero coupon bond prices, illustrate how the model is easily calibrated to market data and show how other interest rate derivatives can be priced.

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    Article provided by Springer in its journal Finance and Stochastics.

    Volume (Year): 4 (2000)
    Issue (Month): 4 ()
    Pages: 409-429

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    Handle: RePEc:spr:finsto:v:4:y:2000:i:4:p:409-429
    Note: received: March 1998; final version received: November 1999
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    1. Longstaff, Francis A & Schwartz, Eduardo S, 1992. " Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model," Journal of Finance, American Finance Association, vol. 47(4), pages 1259-82, September.
    2. Conley, Timothy G, et al, 1997. "Short-Term Interest Rates as Subordinated Diffusions," Review of Financial Studies, Society for Financial Studies, vol. 10(3), pages 525-77.
    3. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
    4. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
    5. Schloegl, Erik & Daniel Sommer, 1997. "Factor Models and the Shape of the Term Structure," Discussion Paper Serie B 395, University of Bonn, Germany.
    6. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    7. Jamshidian, Farshid, 1989. " An Exact Bond Option Formula," Journal of Finance, American Finance Association, vol. 44(1), pages 205-09, March.
    8. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-92.
    9. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
    10. Hiroshi Shirakawa, 1991. "Interest Rate Option Pricing With Poisson-Gaussian Forward Rate Curve Processes," Mathematical Finance, Wiley Blackwell, vol. 1(4), pages 77-94.
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