A Multifactor, Nonlinear, Continuous-Time Model of Interest Rate Volatility
June 1999
Jacob Boudoukh, Matthew Richardson, Richard Stanton, Robert Whitelaw
ABSTRACT
This paper presents a general, nonlinear version of existing multifactor models, such as Longstaff and Schwartz
(1992). The novel aspect of our approach is that rather than choosing the model parameterization out of "thin
air", our processes are generated from the data using approximation methods for multifactor continuous-time
Markov processes. In applying this technique to the short- and long-end of the term structure for a general two-factor
diffusion process for interest rates, a major finding is that the volatility of interest rates is increasing in
the level of interest rates only for sharply upward sloping term structures. In fact, the slope of the term structure
plays a larger role in determining the magnitude of the diffusion coefficient. As an application, we analyze the
model's implications for the term structure of term premiums.
Subject: Investments/Fixed Income, Investments/Econometrics, Investments/Volatility of Asset Prices
Classification: Empirical, Theoretical
Boudoukh: (212) 998-0305 jboudouk@stern.nyu.edu
http://www.stern.nyu.edu/~jboudouk/
Richardson: (212) 998-0349 mrichar0@stern.nyu.edu
http://www.stern.nyu.edu/~mrichar0/
Stanton: (510) 642-7382 stanton@haas.berkeley.edu
Haas School of Business, U.C. Berkeley
Whitelaw (212) 998-0338 rwhitela@stern.nyu.edu
http://www.stern.nyu.edu/~rwhitela/
To download a copy of this paper click here
To request a copy of this paper click here
The Finance Department Working Paper Series has been generously sponsored by