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Markov Chain Approximations For Term Structure Models

Author

Listed:
  • David Backus

    (New York University)

  • Liuren Wu

    (Fordham University)

  • Stanley Zin

    (Carnegie Mellon University)

Abstract
We derive discrete markov chain approximations for continuous state equilibrium term structure models. The states and transition probabilities of the markov chain are chosen effciently according to a quadrature rule as in Tauchen and Hussey (1991). Quadrature provides a simple yet method which can easily incorporates complication like non- normality, heteroskedasticity, and multiple factors. We use the extended Vasicek model of the term structure as an example for this procedure and compare its pricing efficiency and accuracy to the popular trinomial tree approximation of Hull and White (1990). We further illustrate, with numerical examples, the and effciency of this procedure in pricing interest rate options when the underlying interest rate has conditional non-normality and multiple factors.

Suggested Citation

  • David Backus & Liuren Wu & Stanley Zin, 2002. "Markov Chain Approximations For Term Structure Models," Finance 0207018, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0207018
    Note: Type of Document - postcript; prepared on LaTex; to print on postscript; pages: 41 ; figures: included. prepared via dvips
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    More about this item

    Keywords

    markov chain; term structure; interest rates; mean-reversion; quadrature; option pricing;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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