A COMPARISON OF FIXED INCOME VALUATION MODELS PRICING AND.docVIP

A COMPARISON OF FIXED INCOME VALUATION MODELS: PRICING AND ECONOMETRIC ANALYSIS OF INTEREST RATE DERIVATIVES by Michael Jacobs, Jr. A dissertation submitted to the Graduate Faculty in Business in partial fulfillment of the requirements for the degree of Doctor of Philosophy, The City University of New York. 2001  ? 2001 Michael Jacobs, Jr. All Rights Reserved THE CITY UNIVERSITY OF NEW YORK ABSTRACT A COMPARISON OF FIXED INCOME VALUATION MODELS: PRICING AND ECONOMETRIC ANALYSIS OF INTEREST RATE DERIVATIVES by Michael Jacobs, Jr. Advisor: Professor Kishore Tandon This study compares continuous-time stochastic interest rate and stochastic volatility models of interest rate derivatives, examining these models across several dimensions: different classes of models, factor structures, and pricing algorithms. We consider a broader universe of pricing models, using improved econometric and numerical methodologies. We establish several criteria for model quality that are motivated by financial theory as well as practice: realism of the assumed stochastic process for the term structure, consistency with no-arbitrage or financial market equilibrium, consistency with financial practice, parsimony, as well as computational efficiency. A model which scores well along these grounds will also exhibit superior pricing performance with regard to traded interest rate options. This helps resolve the controversies over the stochastic process for yield curve dynamics, the models that best manage and measure interest rate risk, and theories of the term structure that are supported by empirical results. We perform econometric experiments at three levels: the short rate, bond prices, as well as interest rate derivatives. We extend CKLS (1992) to a broader class of single factor spot rate models and international interest rates. We find that a single-factor general parametric model (1FGPM) of the term structure, with non-linearity in the drift function, better captur