Bond valuation under a discrete-time regime-switching term-structure model and its continuous-time extension

Robert J. Elliott*, Tak Kuen Siu, Alex Badescu

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

10 Citations (Scopus)

Abstract

Purpose – The purpose of this paper is to consider a discrete-time, Markov, regime-switching, affine term-structure model for valuing bonds and other interest rate securities. The proposed model incorporates the impact of structural changes in (macro)-economic conditions on interest-rate dynamics. The market in the proposed model is, in general, incomplete. A modified version of the Esscher transform, namely, a double Esscher transform, is used to specify a price kernel so that both market and economic risks are taken into account. Design/methodology/approach – The market in the proposed model is, in general, incomplete. A modified version of the Esscher transform, namely, a double Esscher transform, is used to specify a price kernel so that both market and economic risks are taken into account. Findings – The authors derive a simple way to give exponential affine forms of bond prices using backward induction. The authors also consider a continuous-time extension of the model and derive exponential affine forms of bond prices using the concept of stochastic flows. Originality/value – The methods and results presented in the paper are new.

Original languageEnglish
Pages (from-to)1025-1047
Number of pages23
JournalManagerial Finance
Volume37
Issue number11
DOIs
Publication statusPublished - 27 Sep 2011

Keywords

  • Bonds
  • Continuous-time models
  • Double Esscher transform
  • Exponential affine form
  • Finance modeling
  • Interest rates
  • Markov chain
  • Product density processes
  • Regime switching risk
  • Securities

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