Publication Type

Journal Article

Version

publishedVersion

Publication Date

6-2005

Abstract

Prices of interest rate derivative securities depend crucially on the mean reversion parameters of the underlying diffusions. These parameters are subject to estimation bias when standard methods are used. The estimation bias can be substantial even in very large samples and much more serious than the discretization bias, and it translates into a bias in pricing bond options and other derivative securities that is important in practical work. This article proposes a very general and computationally inexpensive method of bias reduction that is based on Quenouille's (1956; Biometrika, 43, 353-360) jackknife. We show how the method can be applied directly to the options price itself as well as the coefficients in the models. We investigate its performance in a Monte Carlo study. Empirical applications to U.S. dollar swap rates highlight the differences between bond and option prices implied by the jackknife procedure and those implied by the standard approach. These differences are large and suggest that bias reduction in pricing options is important in practical applications.

Keywords

Bias Reduction, Option Pricing, Bond Pricing, Term Structure of Interest Rates, Re-sampling, Estimation of Continuous Time Models

Discipline

Econometrics | Finance and Financial Management

Research Areas

Econometrics

Publication

Review of Financial Studies

Volume

18

Issue

2

First Page

707

Last Page

742

ISSN

0893-9454

Identifier

10.1093/rfs/hhi018

Publisher

Oxford University Press

Copyright Owner and License

Publisher

Additional URL

https://doi.org/10.1093/rfs/hhi018

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