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 language | English |
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Pages (from-to) | 1025-1047 |
Number of pages | 23 |
Journal | Managerial Finance |
Volume | 37 |
Issue number | 11 |
DOIs | |
Publication status | Published - 27 Sept 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