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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