Estimating the Volatility Structure of an Arbitrage-Free Interest Rate Model Via the Futures Markets

Ram Bhar, Carl Chiarella () and Thuy-Duong To
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Ram Bhar: School of Banking & Finance, University of New South Wales
Thuy-Duong To: School of Finance & Economics, University of Technology, Sydney

Finance from EconWPA

Abstract: This paper considers a class of Heath-Jarrow-Morton (1992) term structure models, characterized by time deterministic volatilities for the instantaneous forward rate. The bias that arises from using observed futures yields as a proxy for the unobserved instantaneous forward rate is analyzed. The fact that futures contracts can be viewed as derivative instruments on the forward rate is used to determine the likelihood function for futures prices. The likelihood transformation method of Duan (1994) is then used to obtain the full information maximum likelihood estimator for the observable futures prices. The approach is applied to estimate the volatility structure implied by futures contracts traded on the Chicago Mercantile Exchange.

Keywords: Term structure; Heath-Jarrow-Morton; Yield curve; Forward rate volatility function; Estimation bias; FIML; Likelihood transformation; Futures contracts (search for similar items in EconPapers)
JEL-codes: C51 E43 G12 G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn, nep-ecm, nep-ets, nep-fin, nep-fmk and nep-rmg
Date: 2004-09-01
Note: Type of Document - pdf; pages: 39
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:0409003

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