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Arbitrage‐Based Estimation of Nonstationary Shifts in the Term Structure of Interest Rates

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  • ROBERT R. BLISS
  • EHUD I. RONN

Abstract

The purpose of this paper is to provide a test of a state‐dependent multinomial model of intertemporal changes in the term structure of interest rates. The theoretical background for the model comes from Ho and Lee (1986). The current paper extends their model in several significant ways. First, we perform diagnostic tests on the data to demonstrate that the empirical results reject a binomial model in favor of a trinomial one. After theoretically deriving the appropriate trinomial model, the current paper extends their model to allow for state‐dependent shifts which are determined by the set of ex ante observable state variables. The methodology for the study utilizes OLS regressions to identify the exogenous explanatory variables which drive the hypothesized trinomial process of term structure evolution. The empirical tests indicate that the set of state variables explains a significant portion of the variability in the shifts of the term structure over time. The model also identifies and quantifies a set of variables which impact on changes in the term structure of interest rates.

Suggested Citation

  • Robert R. Bliss & Ehud I. Ronn, 1989. "Arbitrage‐Based Estimation of Nonstationary Shifts in the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 44(3), pages 591-610, July.
    • Handle: RePEc:bla:jfinan:v:44:y:1989:i:3:p:591-610
    DOI: 10.1111/j.1540-6261.1989.tb04380.x
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    Cited by:

    1. Young Shin Kim & Stoyan Stoyanov & Svetlozar Rachev & Frank J. Fabozzi, 2017. "Another Look at the Ho-Lee Bond Option Pricing Model," Papers 1712.06664, arXiv.org.
    2. Boero, G. & Torricelli, C., 1996. "A comparative evaluation of alternative models of the term structure of interest rates," European Journal of Operational Research, Elsevier, vol. 93(1), pages 205-223, August.
    3. Sercu, P., 1991. "Bond options and bond portfolio insurance," Insurance: Mathematics and Economics, Elsevier, vol. 10(3), pages 203-230, December.
    4. Mahendra Raj, 1994. "Pricing options on short-term interest rates using discrete arbitrage-free models," Applied Economics Letters, Taylor & Francis Journals, vol. 1(1), pages 1-3.
    5. Abaffy, Jozsef & Bertocchi, Marida & Gnudi, Adriana, 2005. "Extensions of the Ho and Lee interest-rate model to the multinomial case," European Journal of Operational Research, Elsevier, vol. 163(1), pages 154-169, May.

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