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Term structure; yield curve; interest rate caps; implied volatility; residual factors; extended Kalman Filter; quasi-maximum likelihood estimation.
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Full-Text Articles in Finance and Financial Management
Term Structure Of Interest Rates, Yield Curve Residuals, And The Consistent Pricing Of Interest Rates And Interest Rate Derivatives, Massoud Heidari, Liuren Wu
Term Structure Of Interest Rates, Yield Curve Residuals, And The Consistent Pricing Of Interest Rates And Interest Rate Derivatives, Massoud Heidari, Liuren Wu
CRIF Working Paper series
Dynamic term structure models (DTSMs) price interest rate derivatives based on the modelimplied fair values of the yield curve, ignoring any pricing residuals on the yield curve that are either from model approximations or market imperfections. In contrast, option pricing in practice often takes the market observed yield curve as given and focuses exclusively on the specification of the volatility structure of forward rates. Thus, if any errors exist on the observed yield curve, they will be carried over permanently. This paper proposes a new framework that consistently prices both interest rates and interest rate derivatives. In particular, under such …