Bond and option prices with permanent shocks

Haitham A. Al-Zoubi

Journal of Empirical Finance, 2019, vol. 53, issue C, 272-290

Abstract: I develop and estimate an affine short-rate model that incorporates a nonstationary stochastic mean. In my model, the time-varying stochastic mean is subject to a sequence of permanent shocks that can better capture the source of nonlinearity in the drift than existing models. I find that the proposed model provides a better in-sample and out-of-sample fit to observed interest rates and bond prices relative to extant models. More specifically, my model outperforms constant elasticity of volatility models. It follows that the nonstationary stochastic mean model offers new insights to the implied bond option valuation and accounts for the downward bias in bond option prices generally documented in the literature.

Keywords: Short-term interest rate; Stochastic volatility; Continuous-time estimation; Jackknife (search for similar items in EconPapers)
JEL-codes: C15 C32 G12 (search for similar items in EconPapers)
Date: 2019
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:empfin:v:53:y:2019:i:c:p:272-290

DOI: 10.1016/j.jempfin.2019.07.010

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