Markov Chain Approximations For Term Structure Models

David Backus (), Liuren Wu () and Stanley E. Zin

Finance from EconWPA

Abstract: We derive discrete markov chain approximations for continuous state equilibrium term structure models. The states and transition probabilities of the markov chain are chosen effciently according to a quadrature rule as in Tauchen and Hussey (1991). Quadrature provides a simple yet method which can easily incorporates complication like non- normality, heteroskedasticity, and multiple factors. We use the extended Vasicek model of the term structure as an example for this procedure and compare its pricing efficiency and accuracy to the popular trinomial tree approximation of Hull and White (1990). We further illustrate, with numerical examples, the and effciency of this procedure in pricing interest rate options when the underlying interest rate has conditional non-normality and multiple factors.

Keywords: markov chain; term structure; interest rates; mean-reversion; quadrature; option pricing (search for similar items in EconPapers)
JEL-codes: E43 C63 C61 G12 G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fmk and nep-rmg
Date: 2002-09-01
Note: Type of Document - postcript; prepared on LaTex; to print on postscript; pages: 41 ; figures: included. prepared via dvips
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:0207018

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