Langetieg's model allows the incorporation of an arbitrary number of economic factors into the bond pricing equation. The short- term interest rate is specified as a linear combination of the economic factors, which are assumed to follow a joint elastic random walk. Hence the bond price becomes a function of this linear combination of economic factors. The ability to find a closed-form solution for the bond price depends on the type of process assumed for the economic factors. The elastic random walk results in a normal distribution which makes such a solution possible.

This model makes a theoretical rather than a practical contribution to interest rate modelling. Its contribution lies in the theoretical framework it provides for the incorporation of multiple economic factors. The model parameters are left unspecified, so application of the model requires the specification of the number and type of economic factors determining the short-term interest rate, the estimation of the parameters of the joint elastic random walk process followed by the economic factors and the estimation of the associated market prices of risk. This is a rather challenging exercise giving rise to many estimation complexities.

Interest Rate Modelling (Finance and Capital Markets Series)

ISBN: 1403934703

EAN: 2147483647

EAN: 2147483647

Year: 2004

Pages: 132

Pages: 132

Authors: Simona Svoboda

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