On the relevance of modeling volatility for pricing purposes

Manuel Moreno

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: This paper presents a two-factor (Vasicek-CIR) model of the term structure of interest rates and develops its pricing and empirical properties. We assume that default free discount bond prices are determined by the time to maturity and two factors, the long-term interest rate and the spread. Assuming a certain process for both factors, a general bond pricing equation is derived and a closed-form expression for bond prices is obtained. Empirical evidence of the model's performance in comparisson with a double Vasicek model is presented. The main conclusion is that the modeling of the volatility in the long- term rate process can help (in a large amount) to fit the observed data can improve - in a reasonable quantity - the prediction of the future movements in the medium- and long-term interest rates. However, for shorter maturities, it is shown that the pricing errors are, basically, negligible and it is not so clear which is the best model to be used.

Keywords: Term structure of interest rates; bond pricing equation; two-factor models; Ornstein-Uhlenbeck process; CIR process (search for similar items in EconPapers)
JEL-codes: C51 E43 G13 (search for similar items in EconPapers)
Date: 1997-09, Revised 1999-10
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Persistent link: https://EconPapers.repec.org/RePEc:upf:upfgen:431

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