The Use of Bayes Factors to Compare Interest Rate Term Structure Models

Quantitative Finance, 2013, vol. 13, no. 3, 369-381.

Posted: 8 Oct 2014

See all articles by W. Keener Hughen

W. Keener Hughen

Sacred Heart University

Carmelo Giaccotto

University of Connecticut - Department of Finance

Po-Hsuan Hsu

National Tsing Hua University - Department of Quantitative Finance

Date Written: April 28, 2011

Abstract

Studies of the term structure of interest rates try to explain the relationship between the yield to maturity on zero coupon bonds and their time to maturity. Over the years, many theoretical models have been developed to explain the stylized facts of U.S. Treasury yields; however, model comparison, parameter estimation and hypothesis testing remain thorny issues. The purpose of this paper is to show that Bayesian methods and Markov Chain Monte Carlo (MCMC) methods in particular may help resolve a number of these problems, especially those related to model comparison. We use MCMC to compare the seminal models of Vasicek and Cox, Ingersoll and Ross (CIR). The most surprising result of our analysis is that one of these two models is almost 50,000 times more likely than the other. In contrast, results in the previous literature have been much more ambiguous because they are based on a variety of goodness-of-fit measures. A Monte Carlo study shows that these results are not spurious: the MCMC method is able to select the correct data generation model whereas goodness-of-fit measures are virtually indistinguishable regardless of whether the data were generated from Vasicek or CIR.

Keywords: Markov chain Monte Carlo; Marginal likelihood; Bond price

Suggested Citation

Hughen, W. Keener and Giaccotto, Carmelo and Hsu, Po-Hsuan, The Use of Bayes Factors to Compare Interest Rate Term Structure Models (April 28, 2011). Quantitative Finance, 2013, vol. 13, no. 3, 369-381.. Available at SSRN: https://ssrn.com/abstract=2506306

W. Keener Hughen (Contact Author)

Sacred Heart University ( email )

5151 Park Ave
Fairfield, CT 06432
United States

Carmelo Giaccotto

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States
202-486-4360 (Phone)
202-486-0349 (Fax)

Po-Hsuan Hsu

National Tsing Hua University - Department of Quantitative Finance ( email )

101, Section 2, Kuang-Fu Road
Hsinchu, Taiwan 300
China

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