(Emerald, 2011) Elliott, Robert; Siu, Tak Kuen; Badescu, Alex
Purpose – The purpose of this paper is to consider a discrete-time, Markov, regime-switching, affine
term-structure model for valuing bonds and other interest rate securities. The proposed model
incorporates the impact of structural changes in (macro)-economic conditions on interest-rate
dynamics. The market in the proposed model is, in general, incomplete. A modified version of the
Esscher transform, namely, a double Esscher transform, is used to specify a price kernel so that both
market and economic risks are taken into account.
Design/methodology/approach – The market in the proposed model is, in general, incomplete.
A modified version of the Esscher transform, namely, a double Esscher transform, is used to specify a
price kernel so that both market and economic risks are taken into account.
Findings – The authors derive a simple way to give exponential affine forms of bond prices using
backward induction. The authors also consider a continuous-time extension of the model and derive
exponential affine forms of bond prices using the concept of stochastic flows.