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Markov Chain Approximations For Term Structure Models

Listed author(s):
  • David Backus

    (New York University)

  • Liuren Wu

    (Fordham University)

  • Stanley Zin

    (Carnegie Mellon University)

We derive discrete markov chain approximations for continuous state equilibrium term structure models. The states and transition probabilities of the markov chain are chosen effciently according to a quadrature rule as in Tauchen and Hussey (1991). Quadrature provides a simple yet method which can easily incorporates complication like non- normality, heteroskedasticity, and multiple factors. We use the extended Vasicek model of the term structure as an example for this procedure and compare its pricing efficiency and accuracy to the popular trinomial tree approximation of Hull and White (1990). We further illustrate, with numerical examples, the and effciency of this procedure in pricing interest rate options when the underlying interest rate has conditional non-normality and multiple factors.

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Paper provided by EconWPA in its series Finance with number 0207018.

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Length: 41 pages
Date of creation: 01 Sep 2002
Handle: RePEc:wpa:wuwpfi:0207018
Note: Type of Document - postcript; prepared on LaTex; to print on postscript; pages: 41 ; figures: included. prepared via dvips
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