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Markov Chain Approximations For Term Structure Models

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Author Info
David Backus (New York University)
Liuren Wu (Fordham University)
Stanley Zin (Carnegie Mellon University)

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Abstract

We derive discrete markov chain approximations for continuous state equilibrium term structure models. The states and transition probabilities of the markov chain are chosen effciently according to a quadrature rule as in Tauchen and Hussey (1991). Quadrature provides a simple yet method which can easily incorporates complication like non- normality, heteroskedasticity, and multiple factors. We use the extended Vasicek model of the term structure as an example for this procedure and compare its pricing efficiency and accuracy to the popular trinomial tree approximation of Hull and White (1990). We further illustrate, with numerical examples, the and effciency of this procedure in pricing interest rate options when the underlying interest rate has conditional non-normality and multiple factors.

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Publisher Info
Paper provided by EconWPA in its series Finance with number 0207018.

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Length: 41 pages
Date of creation: 01 Sep 2002
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Handle: RePEc:wpa:wuwpfi:0207018

Note: Type of Document - postcript; prepared on LaTex; to print on postscript; pages: 41 ; figures: included. prepared via dvips
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Web page: http://129.3.20.41

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Related research
Keywords: markov chain; term structure; interest rates; mean-reversion; quadrature; option pricing;

Find related papers by JEL classification:
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
C63 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Computational Techniques
C61 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Optimization Techniques; Programming Models; Dynamic Analysis
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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This page was last updated on 2009-10-20.

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