Stochastic Volatilities and Correlations of Bond Yields
Dice Center Working Paper No. 2003-27
42 Pages Posted: 4 Jan 2004
Date Written: October 2005
Abstract
I develop an interest rate model with separate factors driving innovations in bond yields and their covariances. My model features flexible and tractable affine structure for the covariances of bond yields. Maximum likelihood estimation of the model with panel data on swaptions and discount bonds implies pricing errors for swaptions that are almost always lower than half of the bid-ask spread. Further, market prices of interest rate caps do not deviate significantly from their no-arbitrage values implied by the swaptions under my model. These findings confirm the conjectures by Collin-Dufresne and Goldstein (2003), Dai and Singleton (2003), and Jagannathan, Kaplin and Sun (2003).
Keywords: Stochastic volatility, stochastic correlation, unspanned volatility, string model, relative valuation of swaptions and caps
JEL Classification: G12, G13
Suggested Citation: Suggested Citation
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