Nonparametric Estimation of Convergence of Interest Rates: Effects on Bond Pricing
43 Pages Posted: 7 Jan 2002
We present and estimate, using nonparametric regression techniques, a model of short term interest rate dynamics and use the estimation to value bonds. We study the case of two European countries - Spain and Italy - that belong to EMU, and compare the resulting bond prices of a one factor model with that of a two factor, the second factor being a stochastic mean. The pricing errors for both models are 34% smaller than those reported on the parametric literature. Furthermore, the two factor model, which takes into account the convergence with Europe of the domestic economies, obtains better results than the one factor model. Our findings give strong support to the importance of a correct specification of the volatility of interest rates.
Keywords: Nonparametrics, Interest Rates, Continuous Times, Valuation
JEL Classification: E43, C14
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