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Econometric Modelling of the Euro Using Two-Factor Continuous Time Dynamic Interest Rate Models

K. Ben Nowman, Harry Thapar

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Abstract

The introduction of the Euro and the development of financial instruments based on Euro interest rates has become an important research area. There are now many bonds in the Eurozone area whose pricing depends on the specification of a model of interest rates. In this chapter we consider the modelling of Euro interest rates using well-known continuous time interest rate models. There exist many different models of the short-term interest rate, and the usual startingpoint is the single-factor model of Chan, Karolyi, Longstaff and Sanders (1992, CKLS hereafter), which included many special cases. Two of these special cases are the models of Vasicek (1977) and Cox, Ingersoll and Ross (1985, CIR hereafter), which are used in this chapter.

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What this paper is about

The introduction of the Euro and the development of financial instruments based on Euro interest rates has become an important research area. There are now many bonds in the Eurozone area whose pricing depends on the specification of a model of interest rates. In this chapter we consider the modelling of Euro interest rates using well-known continuous time interest rate models. There exist many different models of the short-term interest rate, and the usual startingpoint is the single-factor model of Chan, Karolyi, Longstaff and Sanders (1992, CKLS hereafter), which included many special cases. Two of these special cases are the models of Vasicek (1977) and Cox, Ingersoll and Ross (1985, CIR hereafter), which are used in this chapter.

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Available abstract

The introduction of the Euro and the development of financial instruments based on Euro interest rates has become an important research area. There are now many bonds in the Eurozone area whose pricing depends on the specification of a model of interest rates. In this chapter we consider the modelling of Euro interest rates using well-known continuous time interest rate models. There exist many different models of the short-term interest rate, and the usual startingpoint is the single-factor model of Chan, Karolyi, Longstaff and Sanders (1992, CKLS hereafter), which included many special cases. Two of these special cases are the models of Vasicek (1977) and Cox, Ingersoll and Ross (1985, CIR hereafter), which are used in this chapter.

Key concepts: Vasicek model, Interest rate, Cox–Ingersoll–Ross model, Short-rate model, Econometrics, Short rate, Rendleman–Bartter model, Economics

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