Online from: 1975
Subject Area: Accounting and Finance
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|Title:||Bond valuation under a discrete-time regime-switching term-structure model and its continuous-time extension|
|Author(s):||Robert J. Elliott, (Haskayne School of Business, University of Calgary, Calgary, Canada and School of Mathematical Sciences, University of Adelaide, Adelaide, Australia), Tak Kuen Siu, (Department of Actuarial Studies and Centre of Financial Risk, Faculty of Business and Economics, Macquarie University, Sydney, Australia), Alex Badescu, (Department of Mathematics and Statistics, University of Calgary, Calgary, Canada)|
|Citation:||Robert J. Elliott, Tak Kuen Siu, Alex Badescu, (2011) "Bond valuation under a discrete-time regime-switching term-structure model and its continuous-time extension", Managerial Finance, Vol. 37 Iss: 11, pp.1025 - 1047|
|Keywords:||Bonds, Continuous-time models, Double Esscher transform, Exponential affine form, Finance modeling, Interest rates, Markov chain, Product density processes, Regime switching risk, Securities|
|Article type:||Technical paper|
|DOI:||10.1108/03074351111167929 (Permanent URL)|
|Publisher:||Emerald Group Publishing Limited|
|Acknowledgements:||The authors would like to thank the referees for their helpful comments. Robert J. Elliott and Tak Kuen Siu wish to acknowledge the Discovery Grant from the Australian Research Council (ARC), (Project No. DP1096243). Alex Badescu wishes to thank NSERC for financial support.|
Purpose – The purpose of this paper is to consider a discrete-time, Markov, regime-switching, affine term-structure model for valuing bonds and other interest rate securities. The proposed model incorporates the impact of structural changes in (macro)-economic conditions on interest-rate dynamics. The market in the proposed model is, in general, incomplete. A modified version of the Esscher transform, namely, a double Esscher transform, is used to specify a price kernel so that both market and economic risks are taken into account.
Design/methodology/approach – The market in the proposed model is, in general, incomplete. A modified version of the Esscher transform, namely, a double Esscher transform, is used to specify a price kernel so that both market and economic risks are taken into account.
Findings – The authors derive a simple way to give exponential affine forms of bond prices using backward induction. The authors also consider a continuous-time extension of the model and derive exponential affine forms of bond prices using the concept of stochastic flows.
Originality/value – The methods and results presented in the paper are new.
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