The Term Structure of Interest Rates in a Hidden Markov Setting

Robert J. Elliott () and Craig A. Wilson ()
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Robert J. Elliott: University of Calgary
Craig A. Wilson: University of Saskatchewan

Chapter 2 in Hidden Markov Models in Finance, 2007, pp 15-30 from Springer

Abstract: Summary We describe an interest rate model in which randomness in the short-term interest rate is partially due to a Markov chain. We model randomness through the volatility and mean-reverting level as well as through the interest rate directly. The short- term interest rate is modeled in a risk-neutral setting as a continuous process in continuous time. This allows the valuation of interest rate derivatives using the martingale approach. In particular, a solution is found for the value of a zero-coupon bond. This leads to a non-linear regression model for the yield to maturity, which is used to filter the state of the unobservable Markov chain.

Keywords: Interest rate modeling; term structure; filtering; Markov chain (search for similar items in EconPapers)
Date: 2007
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Citations: View citations in EconPapers (10)

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Persistent link: https://EconPapers.repec.org/RePEc:spr:isochp:978-0-387-71163-8_2

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DOI: 10.1007/0-387-71163-5_2

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