A Multifactor, Nonlinear, Continuous-Time Model of Interest Rate Volatility
Interdisciplinary Center (IDC) - Rothschild Center
Matthew P. Richardson
New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)
University of California, Berkeley - Finance Group
New York University; National Bureau of Economic Research (NBER)
NYU Working Paper No. FIN-99-042
This paper presents a general, nonlinear version of existing multifactor models, such as Longstaff and Schwartz (1992). The novel aspect of our approach is that rather than choosing the model parameterization out of "thin air", our processes are generated from the data using approximation methods for multifactor continuous-time Markov processes. In applying this technique to the short- and long-end of the term structure for a general two-factor diffusion process for interest rates, a major finding is that the volatility of interest rates is increasing in the level of interest rates only for sharply upward sloping term structures. In fact, the slope of the term structure plays a larger role in determining the magnitude of the diffusion coefficient. As an application, we analyze the model's implications for the term structure of term premiums.
Number of Pages in PDF File: 43working papers series
Date posted: November 11, 2008
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