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294
Forecasting the term structure of government bond yields
 Journal of Econometrics
, 2006
"... Despite powerful advances in yield curve modeling in the last twenty years, comparatively little attention has been paid to the key practical problem of forecasting the yield curve. In this paper we do so. We use neither the noarbitrage approach, which focuses on accurately fitting the cross sectio ..."
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Cited by 287 (16 self)
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Despite powerful advances in yield curve modeling in the last twenty years, comparatively little attention has been paid to the key practical problem of forecasting the yield curve. In this paper we do so. We use neither the noarbitrage approach, which focuses on accurately fitting the cross section of interest rates at any given time but neglects timeseries dynamics, nor the equilibrium approach, which focuses on timeseries dynamics (primarily those of the instantaneous rate) but pays comparatively little attention to fitting the entire cross section at any given time and has been shown to forecast poorly. Instead, we use variations on the NelsonSiegel exponential components framework to model the entire yield curve, periodbyperiod, as a threedimensional parameter evolving dynamically. We show that the three timevarying parameters may be interpreted as factors corresponding to level, slope and curvature, and that they may be estimated with high efficiency. We propose and estimate autoregressive models for the factors, and we show that our models are consistent with a variety of stylized facts regarding the yield curve. We use our models to produce termstructure forecasts at both short and long horizons, with encouraging results. In particular, our forecasts appear much more accurate at long horizons than various standard benchmark forecasts. Finally, we discuss a number of extensions, including generalized duration measures, applications to active bond portfolio management, and arbitragefree specifications. Acknowledgments: The National Science Foundation and the Wharton Financial Institutions Center provided research support. For helpful comments we are grateful to Dave Backus, Rob Bliss, Michael Brandt, Todd Clark, Qiang Dai, Ron Gallant, Mike Gibbons, Da...
A Nonparametric Model of Term Structure Dynamics and the Market Price of Interest Rate Risk
, 1997
"... This article presents a technique for nonparametrically estimating continuoustime di#usion processes which are observed at discrete intervals. We illustrate the methodology by using daily three and six month Treasury Bill data, from January 1965 to July 1995, to estimate the drift and di#usion of t ..."
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Cited by 208 (5 self)
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This article presents a technique for nonparametrically estimating continuoustime di#usion processes which are observed at discrete intervals. We illustrate the methodology by using daily three and six month Treasury Bill data, from January 1965 to July 1995, to estimate the drift and di#usion of the short rate, and the market price of interest rate risk. While the estimated di#usion is similar to that estimated by Chan, Karolyi, Longsta# and Sanders (1992), there is evidence of substantial nonlinearity in the drift. This is close to zero for low and medium interest rates, but mean reversion increases sharply at higher interest rates.
Counterparty Risk and the Pricing of Defaultable Securities
 THE JOURNAL OF FINANCE
, 2001
"... Motivated by recent financial crises in East Asia and the United States where the downfall of a small number of firms had an economywide impact, this paper generalizes existing reducedform models to include default intensities dependent on the default of a counterparty. In this model, firms have c ..."
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Cited by 184 (11 self)
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Motivated by recent financial crises in East Asia and the United States where the downfall of a small number of firms had an economywide impact, this paper generalizes existing reducedform models to include default intensities dependent on the default of a counterparty. In this model, firms have correlated defaults due not only to an exposure to common risk factors, but also to firmspecific risks that are termed “counterparty risks.” Numerical examples illustrate the effect of counterparty risk on the pricing of defaultable bonds and credit derivatives such as default swaps.
Valuing Credit Default Swaps II: Modeling Default Correlations
, 2000
"... This paper extends the analysis in Valuing Credit Default Swaps I: No Counterparty Default Risk to provide a methodology for valuing credit default swaps that takes account of counterparty default risk and allows the payoff to be contingent on defaults by multiple reference entities. It develops a m ..."
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Cited by 125 (4 self)
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This paper extends the analysis in Valuing Credit Default Swaps I: No Counterparty Default Risk to provide a methodology for valuing credit default swaps that takes account of counterparty default risk and allows the payoff to be contingent on defaults by multiple reference entities. It develops a model of default correlations between different corporate or sovereign entities. The model is applied to the valuation of vanilla credit default swaps when the seller may default and to the valuation of basket credit default swaps.
Closedform likelihood expansions for multivariate diffusions
, 2008
"... This paper provides closedform expansions for the loglikelihood function of multivariate diffusions sampled at discrete time intervals. The coefficients of the expansion are calculated explicitly by exploiting the special structure afforded by the diffusion model. Examples of interest in financial ..."
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Cited by 109 (3 self)
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This paper provides closedform expansions for the loglikelihood function of multivariate diffusions sampled at discrete time intervals. The coefficients of the expansion are calculated explicitly by exploiting the special structure afforded by the diffusion model. Examples of interest in financial statistics and Monte Carlo evidence are included, along with the convergence of the expansion to the true likelihood function.
Do Bonds Span the Fixed Income Markets? Theory and Evidence for ‘Unspanned’ Stochastic Volatility
 Journal of Finance
, 2002
"... Most term structure models assume bond markets are complete, i.e., that all fixed income derivatives can be perfectly replicated using solely bonds. However, we find that, in practice, swap rates have limited explanatory power for returns on atthemoney straddles – portfolios mainly exposed to vola ..."
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Cited by 82 (2 self)
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Most term structure models assume bond markets are complete, i.e., that all fixed income derivatives can be perfectly replicated using solely bonds. However, we find that, in practice, swap rates have limited explanatory power for returns on atthemoney straddles – portfolios mainly exposed to volatility risk. We term this empirical feature “unspanned stochastic volatility ” (USV). While USV can be captured within an HJM framework, we demonstrate that bivariate models cannot exhibit USV. We determine necessary and sufficient conditions for trivariate Markov affine systems to exhibit USV. For such USVmodels, bonds alone may not be sufficient to identify all parameters. Rather, derivatives are needed.
Pricing and Hedging in Incomplete Markets
 Journal of Financial Economics
, 2001
"... We present a new approach for positioning, pricing, and hedging in incomplete markets that bridges standard arbitrage pricing and expected utility maximization. Our approach for determining whether an investor should undertake a particular position involves specifying a set of probability measures a ..."
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Cited by 81 (8 self)
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We present a new approach for positioning, pricing, and hedging in incomplete markets that bridges standard arbitrage pricing and expected utility maximization. Our approach for determining whether an investor should undertake a particular position involves specifying a set of probability measures and associated °oors which expected payo®s must exceed in order for the investor to consider the hedged and ¯nanced investment to be acceptable. By assuming that the liquid assets are priced so that each portfolio of assets has negative expected return under at least one measure, we derive a counterpart to the ¯rst fundamental theorem of asset pricing. We also derive a counterPricing and Hedging in Incomplete Markets 2 part to the second fundamental theorem, which leads to unique derivative security pricing and hedging even though markets are incomplete. For products that are not spanned by the liquid assets of the economy, we show how our methodology provides more realistic bidask spreads.
Lévy Processes in Finance: Theory, Numerics, and Empirical Facts
, 2000
"... Lévy processes are an excellent tool for modelling price processes in mathematical finance. On the one hand, they are very flexible, since for any time increment ∆t any infinitely divisible distribution can be chosen as the increment distribution over periods of time ∆t. On the other hand, they have ..."
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Cited by 81 (2 self)
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Lévy processes are an excellent tool for modelling price processes in mathematical finance. On the one hand, they are very flexible, since for any time increment ∆t any infinitely divisible distribution can be chosen as the increment distribution over periods of time ∆t. On the other hand, they have a simple structure in comparison with general semimartingales. Thus stochastic models based on Lévy processes often allow for analytically or numerically tractable formulas. This is a key factor for practical applications. This thesis is divided into two parts. The first, consisting of Chapters 1, 2, and 3, is devoted to the study of stock price models involving exponential Lévy processes. In the second part, we study term structure models driven by Lévy processes. This part is a continuation of the research that started with the author's diploma thesis Raible (1996) and the article Eberlein and Raible (1999). The content of the chapters is as follows. In Chapter 1, we study a general stock price model where the price of a single stock follows an exponential Lévy process. Chapter 2 is devoted to the study of the Lévy measure of infinitely divisible distributions, in particular of generalized hyperbolic distributions. This yields information about what changes in the distribution of a generalized hyperbolic Lévy motion can be achieved by a locally equivalent change of the underlying probability measure. Implications for
Continuoustime methods in finance: A review and an assessment
 Journal of Finance
, 2000
"... I survey and assess the development of continuoustime methods in finance during the last 30 years. The subperiod 1969 to 1980 saw a dizzying pace of development with seminal ideas in derivatives securities pricing, term structure theory, asset pricing, and optimal consumption and portfolio choices. ..."
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Cited by 52 (0 self)
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I survey and assess the development of continuoustime methods in finance during the last 30 years. The subperiod 1969 to 1980 saw a dizzying pace of development with seminal ideas in derivatives securities pricing, term structure theory, asset pricing, and optimal consumption and portfolio choices. During the period 1981 to 1999 the theory has been extended and modified to better explain empirical regularities in various subfields of finance. This latter subperiod has seen significant progress in econometric theory, computational and estimation methods to test and implement continuoustime models. Capital market frictions and bargaining issues are being increasingly incorporated in continuoustime theory. THE ROOTS OF MODERN CONTINUOUSTIME METHODS in finance can be traced back to the seminal contributions of Merton ~1969, 1971, 1973b! in the late 1960s and early 1970s. Merton ~1969! pioneered the use of continuoustime modeling in financial economics by formulating the intertemporal consumption and portfolio choice problem of an investor in a stochastic dynamic programming setting.
ON THE STABILITY OF LOGNORMAL INTEREST RATE MODELS AND THE PRICING OF EURODOLLAR FUTURES
, 1995
"... The lognormal distribution assumption for the term structure of interest is the most natural way to exclude negative spot and forward rates. However, imposing this assumption on the continuously compounded interest rate has a serious drawback: expected rollover returns are innite even if the rollo ..."
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Cited by 41 (2 self)
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The lognormal distribution assumption for the term structure of interest is the most natural way to exclude negative spot and forward rates. However, imposing this assumption on the continuously compounded interest rate has a serious drawback: expected rollover returns are innite even if the rollover period is arbitrarily short. As a consequence such models cannot price one of the most widely used hedging instrument on the Euromoney market, namely the Eurofuture contract. The purpose of this paper is to show that the problem with lognormal models result from modelling the wrong rate, namely the continuously compounded rate. If instead one models the effective annual rate the problem disappears, i.e. the expected rollover returns are nite. The paper studies the resulting dynamics of the continuously compounded rate which is neither normal nor lognormal.