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Enhancing Estimation for Interest Rate Diffusion Models with Bond Prices

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  • Zou, Tao
  • Chen, Song Xi

Abstract

We consider improving estimating parameters of diffusion processes for interest rates by incorporating information in bond prices. This is designed to improve the estimation of the drift parameters, which are known to be subject to large estimation errors. It is shown that having the bond prices together with the short rates leads to more efficient estimation of all parameters for the interest rate models. It enhances the estimation efficiency of the maximum likelihood estimation based on the interest rate dynamics alone. The combined estimation based on the bond prices and the interest rate dynamics can also provide inference to the risk premium parameter. Simulation experiments were conducted to confirm the theoretical properties of the estimators concerned. We analyze the overnight Fed fund rates together with the U.S. Treasury bond prices.

Suggested Citation

  • Zou, Tao & Chen, Song Xi, 2014. "Enhancing Estimation for Interest Rate Diffusion Models with Bond Prices," MPRA Paper 67073, University Library of Munich, Germany, revised Apr 2015.
  • Handle: RePEc:pra:mprapa:67073
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    References listed on IDEAS

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    More about this item

    Keywords

    Interest Rate Models; Affine Term Structure; Bond Prices; Market Price of Risk; Combined Estimation; Parameter Estimation.;
    All these keywords.

    JEL classification:

    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • C50 - Mathematical and Quantitative Methods - - Econometric Modeling - - - General
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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