Bond valuation under a discrete‐time regime‐switching term‐structure model and its continuous‐time extension
Abstract
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.
Keywords
Citation
Elliott, R.J., Kuen Siu, T. and Badescu, A. (2011), "Bond valuation under a discrete‐time regime‐switching term‐structure model and its continuous‐time extension", Managerial Finance, Vol. 37 No. 11, pp. 1025-1047. https://doi.org/10.1108/03074351111167929
Publisher
:Emerald Group Publishing Limited
Copyright © 2011, Emerald Group Publishing Limited