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We propose a semiparametric single-factor diffusion model for the term structure of interest rate. The This model is highly flexible and encompasses most parametric single-factor models proposed in the literature. We fit the semiparametric model to a proxy of the Eurodollar short term interst rate and compare it with the most flexible parametric model found in the literature: First directly, by testing the fully parametric model against the semiparametric one. Secondly, we look at how much the bond prices predicted by the competing models differ; this yields an alternative measure of the performance of the models. The fitted semiparametric model picks up nonlinearities which the fully parameteric model cannot capture. This leads to a rejection of the parametric model in favour of the semiparametric model in the direct comparison of the two fitted models. Moreover, the calculated bond prices implied by the two competing models are shown to be significantly different

Topics:
HG Finance, HB Economic Theory

Publisher: Financial Markets Group, London School of Economics and Political Science

Year: 2004

OAI identifier:
oai:eprints.lse.ac.uk:24741

Provided by:
LSE Research Online

Downloaded from
http://eprints.lse.ac.uk/24741/1/dp501.pdf

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