Pricing Interest Rate Derivatives in a Non-Parametric Two-Factor Term-Structure Model

Bank of Canada Working Paper No. 99-19

55 Pages Posted: 30 Nov 1999

See all articles by John Knight

John Knight

University of Western Ontario, Faculty of Social Science, Deparment of Economics (Deceased)

Fuchun Li

University College of the Cariboo

Mingwei Yuan

Bank of Canada - Department of Monetary and Financial Analysis

Date Written: November 22, 1999

Abstract

Diffusion functions in term-structure models are measures of uncertainty about future price movements and are directly related to the risk associated with holding financial securities. Correct specification of diffusion functions is crucial in pricing options and other derivative securities. In contrast to the standard parametric two-factor models, we propose a non-parametric two-factor term-structure model that imposes no restrictions on the functional forms of the diffusion functions. Hence, this model allows for maximum flexibility when fitting diffusion functions into data. A non-parametric procedure is developed for estimating the diffusion functions, based on the discretely sampled observations. The convergence properties and the asymptotic distributions of the proposed non-parametric estimators of the diffusion functions with multivariate dimensions are also obtained. Based on U.S. data, the non-parametric prices of the bonds and bond options are computed and compared with those calculated under an alternative parametric model. The empirical results show that the non-parametric model generates significantly different prices for the derivative securities.

JEL Classification: C14, C22, G13, E43

Suggested Citation

Knight, John L. and Li, Fuchun and Yuan, Mingwei, Pricing Interest Rate Derivatives in a Non-Parametric Two-Factor Term-Structure Model (November 22, 1999). Bank of Canada Working Paper No. 99-19. Available at SSRN: https://ssrn.com/abstract=195515 or http://dx.doi.org/10.2139/ssrn.195515

John L. Knight

University of Western Ontario, Faculty of Social Science, Deparment of Economics (Deceased)

Fuchun Li

University College of the Cariboo ( email )

900 McGill Road
Kamloops, British Columbia V2C 5N3
Canada

Mingwei Yuan (Contact Author)

Bank of Canada - Department of Monetary and Financial Analysis ( email )

234 Wellington St.
Ottawa, Ontario K1A 0G9
Canada

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