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Bond pricing when the short-term interest rate follows a threshold process

Listed author(s):
  • Wolfgang Lemke
  • Theofanis Archontakis

This paper derives analytical solutions for arbitrage-free bond yields when the short-term interest rate follows an autoregressive process with the intercept switching endogenously. This process from the SETAR family is especially suited to capture the near-unit-root behaviour typically observed in the evolution of short-term interest rates. The derived yield functions, mapping the one-month rate into n-period yields, exhibit a convex/concave shape to the left and right of the threshold value, respectively, a pattern which is also found in US bond yield data. The longer the time to maturity, the more distinct the nonlinearity of the yield function becomes.

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Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 8 (2008)
Issue (Month): 8 ()
Pages: 811-822

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Handle: RePEc:taf:quantf:v:8:y:2008:i:8:p:811-822
DOI: 10.1080/14697680701691451
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