Modelling the term structure of interest rates with general short-rate models (Q1776000): Difference between revisions

The authors employ the Cox-Ingersoll-Ross [\textit{J. C. Cox} et al., Econometrica 53, 385--407 (1985; Zbl 1274.91447)] equilibrium approach as a basic pricing theory where the market price of interest rate risk is derived endogenously. The short-rate process is modelled by the stochastic differential equation \[ dr=\mu(r,t)+\sigma(r,t)dW_t, t\in[0,T], \] where \(W_t\) is a standard Brownian motion, and where \(\mu(r,t)\) and \(\sigma(r,t)\) are drift and diffusion well specified functions. Let \(P(r,t,T)\) be the price of a default-free discount bond at time \(t\) maturing in time \(T\). The bond price in an equilibrium satisfies the partial differential equation \[ \begin{aligned} \frac{1}{2}\sigma^2(r,t)\frac{\partial^2P}{\partial r^2}(r,t,T)+ (\mu(r,t)-\lambda(r,t)\sigma(r,t)) \frac{\partial P}{\partial r}(r,t,T)+ \frac{\partial P}{\partial t}(r,t,T)-rP(r,t,T)&=0,\\ P(r,T,T)&=1, \end{aligned} \] where \(\lambda(r,t)\) can be interpreted as the market price of the interest-rate risk. The authors deal with the risk-adjusted process of the short-rate given by \[ dr=\hat\mu(r,t)+\sqrt{\sigma^2(r,t)}d\widetilde{W}_t, \] where \(\hat\mu(r,t)=\mu(r,t)-\lambda(r,t)\sigma(r,t)\), \(\widetilde{W}_t=W_t+\int_0^t\lambda(r_u,u)\, du\). They approximate the drift and diffusion terms by linear functions \(\hat\mu(r,u)=a_2(t)r_u+a_1(t)u+a_0(t),\) \(\sigma^2(r,u)=b_2(t)r_u+b_1(t)u+b_0(t)\) and obtain a local linear approximation of the last equation. With the approximated process they find a solution to the partial differential equation for the price of a discount bond. The descriptive power of the proposed model is examined empirically by comparing its performance with that of the Cox-Ingersoll-Ross model. The accuracy is also checked by comparing the model implying prices with those calculated by the Monte Carlo method. The empirical analysis confirms that the proposed model outperforms the existing affine term structure model.