On Short Rate Processes and Their Implications for Term Structure Movements
We compare short rate diffusion models with respect to their implications for term structure movements, the plausiblity of which serves us as a criterion for evaluating the models. Analytically for Gauss-Markov models and numerically for a broader collection of models prevalent in the literature, we isolate the deformations of the term structure generated endogenously. Among other analytical tools we use spread options on the forward rate curve as an aggregate measure of term structure shapes across states. On the basis of our analysis we conclude that the Ho/Lee model should be discarded, since it cannot explain the emergence of downward sloping term structures, that the introduction of mean reversion is essential in order to generate downward sloping term structures in any substantial proportion, that the models typically favor upward sloping term structures for short maturities and downward sloping term structures for longer maturities, and that there is a surprisingly strong similarity among many of the models prevalent in the literature. A model which allows arbitrary boundaries for the short rate realizations to be fixed exogenously completes our analysis.
|Date of creation:||Oct 1994|
|Date of revision:|
|Contact details of provider:|| Postal: Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany|
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References listed on IDEAS
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- K. Sandmann & Sandmann, K., 1995. "The Direct Approach to Debt Option Pricing," Discussion Paper Serie B 212, University of Bonn, Germany.
- Flesaker, Bjorn, 1993. "Testing the Heath-Jarrow-Morton/Ho-Lee Model of Interest Rate Contingent Claims Pricing," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(04), pages 483-495, December.
- Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
- Rady, Sven, 1994. "The Direct Approach to Debt Option Pricing," Munich Reprints in Economics 3404, University of Munich, Department of Economics.
- Hull, John & White, Alan, 1990. "Valuing Derivative Securities Using the Explicit Finite Difference Method," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(01), pages 87-100, March.
- K. Sandmann & Sondermann, D., 1993. "A Term Structure Model and the Pricing of Interest Rate Derivative," Discussion Paper Serie B 180, University of Bonn, Germany.
- Ho, Thomas S Y & Lee, Sang-bin, 1986. " Term Structure Movements and Pricing Interest Rate Contingent Claims," Journal of Finance, American Finance Association, vol. 41(5), pages 1011-29, December.
- Stambaugh, Robert F., 1988. "The information in forward rates : Implications for models of the term structure," Journal of Financial Economics, Elsevier, vol. 21(1), pages 41-70, May.
- Hull, John & White, Alan, 1993. "One-Factor Interest-Rate Models and the Valuation of Interest-Rate Derivative Securities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(02), pages 235-254, June.
- Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-92.
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