Level Dependence in Volatility in Linear-Rational Term Structure Models

The degree of level dependence in interest rate volatility is analysed in the linearrational term structure model. The linear-rational square-root (LRSQ) model, where level dependence is set a priori, is compared to a specification where the factor process follows CEV-type dynamics which allows a more flexible degree of level dependence. Parameters are estimated using an unscented Kalman filter in conjunction with quasi-maximum likelihood. An extended specification for the state price density process is required to ensure reliable parameter estimates. The empirical analysis indicates that the LRSQ model generally overestimates level dependence. Although the CEV specification captures the degree of level dependence in volatility more accurately, it has a trade-off with analytical tractability. The optimal specification, therefore, depends on the type of model implementation and general economic conditions.

Grantor

African Institute of Financial Markets and Risk Management

Year dc:date.issued

2019

Author dc:creator

• Ramnarayan, Kalind

Advisor dc:contributor.advisor

• Backwell, Alex

• Mathematical Finance

Handle dc:identifier.uri

http://hdl.handle.net/11427/31207

OAI identifier oai:identifier

oai:open.uct.ac.za:11427/31207