A New Approach to the Valuation of Interest Rate Derivatives: Arrow-Debreu Prices Implicit in the Term Structure of Interest Rates

Abstract:     
In a complete, arbitrage-free securities market, the value of a discount bond is modeled in terms of the pricing kernel and the transition density function of the spot interest rate process. The prices of discount bonds are taken from the current term structure of interest rates, and the transition density function is estimated from historical term structure data, using both parametric and nonparametric techniques. The pricing kernel and associated prices of Arrow-Debreu securities are then determined. The resulting Arrow-Debreu prices have two merits: they are consistent with the current term structure of interest rates, and therefore arbitrage-free, and, in addition, they embody the observed historical behavior of the term structure.

JEL Classifications: G13, E43, G00

Working Paper Series