Munich Personal RePEc Archive

Enhancing Estimation for Interest Rate Diffusion Models with Bond Prices

Zou, Tao and Chen, Song Xi (2014): Enhancing Estimation for Interest Rate Diffusion Models with Bond Prices. Forthcoming in: Journal of Business and Economics Statistics (2015)


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We consider improving estimating parameters of diffusion processes for interest rates by incorporating information in bond prices. This is designed to improve the estimation of the drift parameters, which are known to be subject to large estimation errors. It is shown that having the bond prices together with the short rates leads to more efficient estimation of all parameters for the interest rate models. It enhances the estimation efficiency of the maximum likelihood estimation based on the interest rate dynamics alone. The combined estimation based on the bond prices and the interest rate dynamics can also provide inference to the risk premium parameter. Simulation experiments were conducted to confirm the theoretical properties of the estimators concerned. We analyze the overnight Fed fund rates together with the U.S. Treasury bond prices.

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