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Modeling the Term Structure of Interest Rates with General Diffusion Processes: A Moment Approximation Approach

  • Takamizawa, Hideyuki
  • Shoji, Isao

We propose an analytical approximation of the term structure of interest rates under general diffusion processes of the short-rate and state variables. A method of approximating conditional moments as the solution to a system of ordinary differential equations is applied to the pricing of bonds. Numerical experiments based on two illustrative models show that the second-order approximation is accurate for maturities of up to five years and the third-order approximation is effective for longer maturities. We also show the possibility of improving the second-order approximation without much increasing the computational burden.

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File URL: http://hermes-ir.lib.hit-u.ac.jp/rs/bitstream/10086/16977/1/070econDP06-05.pdf
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Paper provided by Graduate School of Economics, Hitotsubashi University in its series Discussion Papers with number 2006-05.

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Length: 17, [9] p.
Date of creation: Oct 2007
Date of revision:
Handle: RePEc:hit:econdp:2006-05
Note: This version: October, 2007 (The previous version: October, 2006)
Contact details of provider: Phone: +81-42-580-8000
Web page: http://www.econ.hit-u.ac.jp/

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  1. 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.
  2. Pierluigi Balduzzi & Sanjiv Ranjan Das & Silverio Foresi, 1998. "The Central Tendency: A Second Factor In Bond Yields," The Review of Economics and Statistics, MIT Press, vol. 80(1), pages 62-72, February.
  3. Andersen, Torben G. & Lund, Jesper, 1997. "Estimating continuous-time stochastic volatility models of the short-term interest rate," Journal of Econometrics, Elsevier, vol. 77(2), pages 343-377, April.
  4. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  5. Durham, Garland B., 2003. "Likelihood-based specification analysis of continuous-time models of the short-term interest rate," Journal of Financial Economics, Elsevier, vol. 70(3), pages 463-487, December.
  6. Bali, Turan G., 2000. "Testing the Empirical Performance of Stochastic Volatility Models of the Short-Term Interest Rate," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(02), pages 191-215, June.
  7. Knez, Peter J & Litterman, Robert & Scheinkman, Jose Alexandre, 1994. " Explorations into Factors Explaining Money Market Returns," Journal of Finance, American Finance Association, vol. 49(5), pages 1861-82, December.
  8. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
  9. 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.
  10. Brenner, Robin J. & Harjes, Richard H. & Kroner, Kenneth F., 1996. "Another Look at Models of the Short-Term Interest Rate," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(01), pages 85-107, March.
  11. Ahn, Dong-Hyun & Gao, Bin, 1999. "A Parametric Nonlinear Model of Term Structure Dynamics," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 721-62.
  12. Hideyuki Takamizawa & Isao Shoji, 2004. "On the accuracy of the local linear approximation for the term structure of interest rates," Quantitative Finance, Taylor & Francis Journals, vol. 4(2), pages 151-157.
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