On the accuracy of the local linear approximation for the term structure of interest rates

Hideyuki Takamizawa and Isao Shoji

Quantitative Finance, 2004, vol. 4, issue 2, 151-157

Abstract: We examine by numerical experiments the accuracy of an analytical approximation for the nonlinear term structure of interest rates, which is obtained by applying the local linear approximation to a generally specified process of the short rate. Under various short-rate models, we compare discount-bond prices computed by the approximation with those calculated by the Monte Carlo method as the benchmark, which shows that deviations are small. Also in this paper, we show that the approximation originally derived in single-factor framework can be easily extended to a multifactor counterpart. We examine the accuracy using an illustrative two-factor model, which also shows the approximation is accurate.

Date: 2004
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DOI: 10.1080/14697680400000019

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