A New Approach to the Valuation of Interest Rate Derivatives: Arrow-Debreu Prices Implicit in the Term Structure of Interest Rates

31 Pages Posted: 12 Oct 1998

See all articles by Padideh Jalali

Padideh Jalali

University of Massachusetts Amherst - Isenberg School of Management

Hossein B. Kazemi

University of Massachusetts at Amherst - Isenberg School of Management

Date Written: September 1998

Abstract

In a complete, arbitrage-free securities market, the value of a discount bond is modeled in terms of the pricing kernel and the transition density function of the spot interest rate process. The prices of discount bonds are taken from the current term structure of interest rates, and the transition density function is estimated from historical term structure data, using both parametric and nonparametric techniques. The pricing kernel and associated prices of Arrow-Debreu securities are then determined. The resulting Arrow-Debreu prices have two merits: they are consistent with the current term structure of interest rates, and therefore arbitrage-free, and, in addition, they embody the observed historical behavior of the term structure.

JEL Classification: G13, E43, G00

Suggested Citation

Jalali, Padideh and Kazemi, Hossein B., A New Approach to the Valuation of Interest Rate Derivatives: Arrow-Debreu Prices Implicit in the Term Structure of Interest Rates (September 1998). Available at SSRN: https://ssrn.com/abstract=131748 or http://dx.doi.org/10.2139/ssrn.131748

Padideh Jalali (Contact Author)

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States
413-256-0535 (Phone)
413-545-3858 (Fax)

Hossein B. Kazemi

University of Massachusetts at Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States

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