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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