Computing Arbitrage-Free Yields in Multi-Factor Gaussian Shadow Rate Term Structure Models
Marcel A. Priebsch
Abstract:This paper develops an approximation to arbitrage-free bond yields in Gaussian shadow rate term structure models. In this class of models, yields are constrained to be above an effective lower bound, thus rendering standard bond pricing methods inapplicable. I propose approximating the nonlinear relationship between yields and state variables using moments of the censored normal distribution. In an empirical application, this approximation technique is accurate to within a fraction of a basis point. As I show,… Show more
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