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Affine Bond Pricing with a Mixture Distribution for Interest Rate Time-Series DynamicsCreation-Date: 20100225

  • Torben B. Rasmussen


    (School of Economics and Management, Aarhus University, Denmark)

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    Starting from the discrete-time affine term structure model by Dai, Le & Singleton (2006), this paper proposes a Radon-Nikodym derivative which implies that factors follow a mixture distribution under the physical measure. The model thus maintains attractive features of an affine relation between yields and factors, while allowing for nonlinear and non-normal time-series dynamics. Empirically the fit of the discrete-time 3-factor affine model is found to be substantially improved by the inclusion of two components to describe the time-series dynamics. Relative to the risk-neutral model, the mixture model is able to let the variance of the one-period rate be higher and faster increasing in the variance factor, and to introduce negative skewness and positive excess kurtosis. When weights on the components depend on factors, the model produces a speed of mean reversion and variance of the one-period rate that both increase fast with higher levels of the yield curve. The added second component is found to capture infrequent relatively large simultaneous shifts in direction of a yield curve that is at a lower level, is steeper, and is more positively curved.

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    Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2010-11.

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    Length: 54
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    Handle: RePEc:aah:create:2010-11
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    1. Ravi Bansal & Hao Zhou, 2001. "Term structure of interest rates with regime shifts," Finance and Economics Discussion Series 2001-46, Board of Governors of the Federal Reserve System (U.S.).
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    4. Cheridito, Patrick & Filipovic, Damir & Kimmel, Robert L., 2007. "Market price of risk specifications for affine models: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 83(1), pages 123-170, January.
    5. Yacine Ait-Sahalia, 1995. "Nonparametric Pricing of Interest Rate Derivative Securities," NBER Working Papers 5345, National Bureau of Economic Research, Inc.
    6. Pearson, Neil D & Sun, Tong-Sheng, 1994. " Exploiting the Conditional Density in Estimating the Term Structure: An Application to the Cox, Ingersoll, and Ross Model," Journal of Finance, American Finance Association, vol. 49(4), pages 1279-1304, September.
    7. Monika Piazzesi, 2001. "An Econometric Model of the Yield Curve with Macroeconomic Jump Effects," NBER Working Papers 8246, National Bureau of Economic Research, Inc.
    8. Yacine Ait-Sahalia, 1995. "Testing Continuous-Time Models of the Spot Interest Rate," NBER Working Papers 5346, National Bureau of Economic Research, Inc.
    9. 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.
    10. Hamilton, James D., 1988. "Rational-expectations econometric analysis of changes in regime : An investigation of the term structure of interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 385-423.
    11. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 55(5), pages 1943-1978, October.
    12. Jefferson Duarte, 2004. "Evaluating an Alternative Risk Preference in Affine Term Structure Models," Review of Financial Studies, Society for Financial Studies, vol. 17(2), pages 379-404.
    13. Darrell Duffie & Rui Kan, 1996. "A Yield-Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406.
    14. Piazzesi, Monika, 2001. "An Econometric Model of the Yield Curve With Macroeconomic Jump Effects," University of California at Los Angeles, Anderson Graduate School of Management qt5946p7hn, Anderson Graduate School of Management, UCLA.
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