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

Bond valuation under a discrete‐time regime‐switching term‐structure model and its... 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. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Managerial Finance Emerald Publishing

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

Managerial Finance , Volume 37 (11): 23 – Sep 27, 2011

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References (48)

Publisher
Emerald Publishing
Copyright
Copyright © 2011 Emerald Group Publishing Limited. All rights reserved.
ISSN
0307-4358
DOI
10.1108/03074351111167929
Publisher site
See Article on Publisher Site

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.

Journal

Managerial FinanceEmerald Publishing

Published: Sep 27, 2011

Keywords: Bonds; Securities; Interest rates; Finance modeling; Double Esscher transform; Regime switching risk; Markov chain; Exponential affine form; Continuous‐time models; Product density processes

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