Stochastic Volatilities and Correlations of Bond Yields

Dice Center Working Paper No. 2003-27

42 Pages Posted: 4 Jan 2004

See all articles by Bing Han

Bing Han

University of Toronto, Rotman School of Management

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

Han, Bing, Stochastic Volatilities and Correlations of Bond Yields (October 2005). Dice Center Working Paper No. 2003-27, Available at SSRN: https://ssrn.com/abstract=483624 or http://dx.doi.org/10.2139/ssrn.483624

Bing Han (Contact Author)

University of Toronto, Rotman School of Management ( email )

Toronto, Ontario M5S 3E6
Canada
4169460732 (Phone)

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