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On a consistent state-space bond markets model for pricing long-maturity bonds

Author

Listed:
  • Dennis Ikpe

    (Department of Statistics and Probability, Michigan State University, USA†African Institute for Mathematical Sciences, South Africa)

  • Yethu Sithole

    (��Department of Mathematical Sciences, University of South Africa, South Africa)

  • Samuel Asante Gyamerah

    (�Department of Statistics and Actuarial Science, Kwame Nkrumah University of Science and Technology, Ghana¶Laboratory for Interdisciplinary Statistical Analysis – Kwame Nkrumah University of Science and Technology (KNUST-LISA), Kumasi-Ghana)

Abstract

In most financial markets, prices for long-maturity derivatives are not readily available due to illiquidity. This reality is particularly common in bond markets, as it is very challenging to model prices consistently—for medium-to-long-term bonds under a single specification of the underlying interest rate process. We develop a bond market state-space model that incorporates uncertainty in the underlying interest rate process parameters. Our state-space representation, coupled with the complementary Kalman filtering, provides a modeling configuration that permits for liquidity risk management and pricing that is designed in a consistent fashion for both medium- and long-term bonds. As an example, we constructed a state-space bond market modeling system formulated on the two-factor Vasicek interest rate model. Wherein, the interest rate model is subject to noise for medium-to-long-term bond maturities and follows an unobservable process. We demonstrate our Kalman filter algorithm using the observed United States (US) 10 year bond yield data.

Suggested Citation

  • Dennis Ikpe & Yethu Sithole & Samuel Asante Gyamerah, 2022. "On a consistent state-space bond markets model for pricing long-maturity bonds," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 9(04), pages 1-30, December.
    • Handle: RePEc:wsi:ijfexx:v:09:y:2022:i:04:n:s2424786322500244
    DOI: 10.1142/S2424786322500244
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    Keywords

    Infinite horizon; partial observation; uncertainty; illiquidity; state-space representation; price consistency; bond market; Kalman filter;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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