AN EMPIRICAL TEST OF A CONTINUOUS-TIME ARBITRAGE PRICING MODEL FOR DEFAULT-FREE BONDS
Abstract
A single-factor continuous-time model of the term structure of interest rates is tested empirically. Model parameters are estimated using a sample diffusion of short-term rates, and the resulting estimated model is used to price a time series of cross sections of U.S. Treasury securities. Principle results include: (1) the apparent presence of differential taxation of ordinary versus capital gains income, (2) the apparent presence of a stochastic liquidity premium, (3) the ability of the resulting model to explain 75% of the variance of the returns on a sample of Treasury securities, and (4) a near one-to-one correspondence between estimates of the market value of the call option on utility bonds and the corresponding predicted model value. The methodology employed includes a numerical methods solution to a partial differential equation for the price of a default-free bond, and standard statistical tests. Also included are simulation experiments designed to test the robustness of the parameter estimation procedure, and a technique designed to find the set of parameter value estimates that minimizes the summed-squared-differences between the model prices and the actual market prices of the sampled bonds.
Degree
Ph.D.
Subject Area
Management
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