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Bond Pricing when the Short-Term Interest Rate Follows a Threshold Process

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Lemke, Wolfgang; Archontakis, Theofanis

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Abstract This paper derives analytical solutions for arbitrage-free bond yields when the short-term interest rate follows an autoregressive process with the intercept switching endogenously. This process from the SETAR family is especially suited to capture the near-unit-root behavior typically observed in the evolution of short-term interest rates. The derived yield functions, mapping the one-month rate into n-period yields, exhibit a convex/concave shape to the left and the right of the threshold value, respectively; a pattern which is also found in US bond yield data. The longer the time to maturity, the more distinct the nonlinearity of the yield function becomes.
Classification Financial Planning, Accountancy; Economic Statistics, Econometrics, Business Informatics
Method theory application
Free Keywords Bond pricing; Term structure of interest rates; Threshold models
Document language English
Publication Year 2008
Page/Pages p. 811-822
Journal Quantitative Finance, 8 (2008) 8
Status Postprint; peer reviewed
Licence PEER Licence Agreement (applicable only to documents from PEER project)