Stochastic interest rates under rational inattention

Yuhua Zhang, Yingjie Niu and Ting Wu

The North American Journal of Economics and Finance, 2020, vol. 54, issue C

Abstract: This paper introduces state uncertainty due to information-processing constraints into the Vasicek model to examine the impacts of rational inattention. By exploiting the term structure of interest rates, we derive closed-form solutions for the subjective bond price and the corresponding bond yield and find that uncertainty induced by informational frictions plays vital roles in undervaluing the bond price and overestimating the bond yield. Furthermore, we clarify the applications of interest rate dynamics under rational inattention and generate the following results: (i) there is an ambiguous relationship between the investor’s channel capacity and option price; (ii) an increase in state uncertainty via a change in the degree of channel capacity is likely to accelerate investment.

Keywords: Term structure of interest rates; Rational inattention; Kalman-Bucy filtering; Option pricing; Investment timing (search for similar items in EconPapers)
JEL-codes: D91 E22 G30 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecofin:v:54:y:2020:i:c:s1062940820301558

DOI: 10.1016/j.najef.2020.101258

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