GANGADHARAN, VENKAT; PHD

TEMPLE UNIVERSITY, 1996

ECONOMICS, FINANCE (0508)

A model of the term structure of interest rates is developed for a spot rate
process that is characterized by

jump-diffusion and stochastic volatility. An innovation here is the jump-diffusion
process for the variance

of the spot rate. Three related topics are discussed in the general framework
of the jump-diffusion

stochastic volatility term structure model. One, the Ahn-Thompson jump-diffusion
general equilibrium

model is specialized to a two-factor model. A jump-diffusion and stochastic
volatility process for the spot

interest rate is obtained endogenously and a closed-form solution for discount
bond prices is derived. It

is shown that ignoring the jump risk in the economy leads to overstated bond
prices. The model is also

empirically tested using daily data on yields for Treasury instruments. Results
show that the

jump-diffusion stochastic volatility model provides a superior fit to the data
as compared with the

competing equilibrium models of Cox-Ingersoll-Ross, Ahn-Thompson, and Longstaff-Schwartz.
Also,

there is some evidence to support the presence of a jump risk premium implicit
in the bond pricing

formula. Two, the equilibrium term structure model is extended to the no-arbitrage
approach of

Heath-Jarrow-Morton. An option pricing formula is derived in this framework
and it is tested using

simulations. It is shown that a model with fixed parameters can generate significant
errors in option prices

as compared with an arbitrage-based model with time-varying components. Three,
the equilibrium model

is used to derive the prices of some interest rate contingent claims such as
interest rate futures and

forward contracts, options on discount bonds and options on discount bond futures.
It is found that,

given the jump risk in the economy, continuous models of the term structure
typically overstate prices of

interest rate futures, forwards, and call options on discount bonds and discount
bond futures. These

models also understate the prices of put options on discount bonds and discount
bond futures.

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