A Semi-Nonparametric Model of the Pricing Kernel and Interest Rates

Yuriy Kitsul University of North Carolina - Chapel Hill kitsul@email.unc.edu November 29, 2004

Introduction and Motivation

Models of the short-term (risk-free) interest rate describe the time-series dynamics of the yield of the bond of instantaneous maturity (in the continuous time set-up), which serves as a discount rate of risk-adjusted cash-ows in numerous nancial applications

Dynamic models of the term structure of interest rates describe: - how bond yields depend on time to maturity at each moment of time - how the form of this dependence changes with time

Need a model, which would produce a good t of bond yields

Yuriy Kitsul 1

Objectives

To model the pricing kernel and bond yields in a exible pure-diusion framework that allows - to introduce various levels of model complexity semi-nonparametrics - to have closed-form solutions for bond yields eigenfunctions

Within the oered framework to let the data decide on the level of model complexity/number on semi-nonparametric terms/elements

Yuriy Kitsul

Two Major Themes

Semi-nonparametrics: - Flexibility (as in nonparametrics) 1) information about unknown relationships 2) identication of mispriced securities - Closed form expressions of the stochastic processes of interest (as in parametric models) Empirical suciency of pure diusions (motivated by problematic hedging properties of jumps, e.g. review and discussion by Jones (2003) in the context equity options)

Yuriy Kitsul

In this presentation

Methodology: - Model the unknown functional relationship between the pricing kernel and the state variables - Explore the implications for the bond yields, the short risk-free interest rate and the market price of risk. - Oer two methods of implementing the no-arbitrage condition. Empirics: - Estimate the model with Gallant&Tauchens (2004) EMM-MCMC - Find that one factor model with a sucient, but not too high, number of semi-nonparametric terms can not be rejected by the univariate yields data.
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Current Issues and Some Recent Literature - 1, Modeling 1

Bt(T ), price at time t of a zero-coupon bond maturing and paying 1 dollar at time T > t: P MtBt(T ) = Et {MT 1} (1) where P is the physical, or real-world, probability measure, Mt is the instantaneous stochastic discount factor, or pricing kernel, which assigns prices at time t to payos at time t + dt.

The pricing kernel, Mt,T , which assigns prices at time t to payos at time T T > t is Mt,T = M Mt and the price of bond becomes:
P Bt(T ) = Et {Mt,T 1}

(2)
5

Yuriy Kitsul

Current Issues and Some Recent Literature - 1, Modeling 2

Under risk-neutral probability measure, Q, which exists and is unique under absence of arbitrage and completeness: Bt(T ) = 1} (3) where rs is instantaneous (short-term) risk-free interest rate, or money market spot interest rate. To switch back to physical measure, P , Girsanov theorem is used: Bt(T ) =
P Et {e t rsds
T

Q tT rs ds Et {e

t,T 1}
T T

(4) depends on

where Radon-Nikodym derivative t,T = s, known as the market price of risk.

Yuriy Kitsul

2 ( t s dWs 1 s ds) 2 t e

Current Issues and Review of Some Recent Literature - 2, Term Structure Literature 1.

Depending on how rs is modeled, the literature can be categorized into the following types of models: ane (eg. Dai/Singleton(00)) non-linear (eg. quadratic: Ahn/Dittmar/Gallant(02), Ahn/Dittmar/Gallant/Gao(03)) regime-shift1(eg. Bansal/Zhou(02),Bansal/Tauchen/Zhou(03)) jump-diusion (eg. Due/Pan/Singleton(00))

Relatively simple specication for underlying factors to obtain closed-form bond pricing formulas. Complexity is usually achieved by adding extra factors, jumps or regime shifts.
1 Often in a discrete time framework

Yuriy Kitsul

Current Issues and Review of Some Recent Literature - 2, Term Structure Literature 2

Some empirical features of the existing term-structure models:

A test of empirical model is a joint test of specications for the short-term risk-free interest rate and the market price of risk, i.e. test of a model for the pricing kernel.

The debate on which approach is empirically preferable is unresolved yet (eg. constant sign of risk premium and trade-o between a structure of volatility and negative correlation in ane models).

Yuriy Kitsul

Current Issues and Some Recent Literature - 3, Time Series Dynamics of the Short Interest Rate - 1

Use a proxy for the short interest rate, rt, e.g. three-month Treasury bill rate, which may be a problem according to Chapman, Long and Pearson (1997) No need for closed-form bond price solutions More sophisticated specications for rt, which are tested separately, not jointly with specication for the market price of risk

Yuriy Kitsul

Current Issues and Some Recent Literature - 3, Time Series Dynamics of the Short Interest Rate -2

Can categorized into: - one-factor non-linear diusions (e.g. A t-Sahalia (96)) - stochastic volatility (e.g. Andersen and Lund (97)) - regime-shifts (e.g Ang and Bekaert (00)) - jump-diusions (e.g. Johannes (04)) A variety of estimation methods: A t-Sahalia (96), Conley, Hansen, Luttmer and Scheinkman (97), Gallant and Tauchen (98), Eraker(01), Durham(03) and others

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10

In This Work - 1, Questions

Is a exible pure diusion framework empirically sucient? How many factors/state variables are needed? Do we really need any proxies for instantaneous risk-free interest rate to study non-linearities in its dynamics? What do bond yields of longer maturities tell us about its behavior? What is the functional form that describes how investors risk preferences react to the underlying shocks?

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11

Essence of Approach - 1

A1: a factor/state variable xt, which drives the economy and is governed by: dxt = (xt)dt + (xt)dWt, l < x < u (5)

A2: a pricing kernel, Mt and it is some real-valued and positive function, M (xt) L2(q ):
u

Mt = M (xt) such that

l

M (x)2q (x)dx <

(6)

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12

Essence of Approach - 2

such function, M (x), can be expanded on an innite number of orthogonal terms, i(x), such that
u i(x)j (x)q (x)dx l

h2 i , if i = j , where hi is called norm 0 otherwise

Therefore,

Mt =
i=0

aii(xt)

(7)

where ai =

function q (x).
Yuriy Kitsul 13

1 h2 i

u i(x)M (x)q (x)dx l

- an inner product w/r to the weighting

Essence of Approach - 3

i(x) are eigenfunctions = closed form bond-prices Truncate expansion to a nite number of terms, assume some specic form for xt, and, thus, for eigenfunctions, and estimate ai from the data H0: Given parametric specication for underlying factors and a number of terms in the expansion, are there parameter values, for which the modeled pricing kernel is an acceptable representation of the true pricing kernel?

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14

Another Brief Digression into the Literature

Non-linear empirical pricing kernel literature: Bansal/Viswanathan(1993), Bansal/Hseih/Viswanathan(1993), Chapman(1997), and others. What is dierent in this work: - Latent state variables, interest rates application and closed form prices Papers that discuss eigenfunctions2: Hansen/Scheinkman/Touzi(1998), Chen/Hansen/Scheinkman(2000), Meddahi(2001a,b), Florens/Renault/Touzi(1998), Gorovoi/Linetsky(2003) and others Rogers (1997) uses eigenfunctions to form the potential and presents bond pricing formulas, but implementation issues are not obvious
2 Some of the following discussion will be based on the rst three sources

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15

Eigenfunctions Framework - 1

A diusion process that governs xt can also be described by an innitesimal generator, A: A(x) = (x)(x) + 0.5 (x)(x) (8)

Dene scale function, S (x), and speed density, m(x), (Karlin/Taylor(81))

x

S (x) = where s(x) = exp(

x 2( ) d ) 2 ( )

s( )d

(9)

m(x) =

1 s(x) 2(x)

(10)

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16

Eigenfunctions Framework - 2

Density of stationary distribution, dened as q (x) = lims p(x, s|y, t): m(x) q (x) = r m( )d l Consider the following equation (l < x < u): A(x) = (x) which is the same as 1 2 (x)(x) + (x)(x) + (x) = 0 2
Yuriy Kitsul

(11)

(12)

(13)

17

Eigenfunctions Framework - 3

Under some appropriate boundary protocol there will be a countable number of functions, i(x) and constants i, which solve this equation and are orthogonal w/r to a stationary density q (x). i(x) - ith eigenfunction of A and i - corresponding ith eigenvalue. Crucial property: E (i(xT )|Ft) = ei(T t)i(xt)

(14)

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18

Eigenfunctions Framework - 4, Some Examples

O-U process of a form below has q (x) = e with eigenfunctions of its generator equal to Hermite polynomials and eigenvalues i = i dxt = xtdt + 2dWt H0(xt) = 1, H1(xt) = xt, Hi(xt) =
1 (x H i t i 1

x 2

i 1Hi2(xt))

CIR process of a form below has q (x) = xex with eigenfunctions of its generator equal to Laguerre polynomials and eigenvalues i = i dxt = ( + 1 xt)dt + 2 xtdWt

L 0 (xt ) = 1, L1 (xt ) =
Yuriy Kitsul

1+ xt 1+

19

Bond Pricing - 1

Recall that we represent a stochastic discount factor, Mt, as Mt =

n i=0 ai i (xt )

and Bt(T ), price at time t of a zero-coupon bond maturing at T > t: MtBt(T ) = Et(MT 1) Substituting an expression for the pricing kernel, we obtain:
n n

(
i=0

aii(xt))Bt(T ) = Et(
i=0

aii(xT ))

(15)

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20

Bond Pricing - 2

Using the property of eigenfunctions, Et(i(xT )) = ei(T t)i(xt),

n i (T t) i(xt) i=0 ai e n i=0 ai i (xt ) n

Bt(T ) = =

(16)

i=0

aii(xt) i (T t) e n j =0 aj j (xt )

Instantaneous risk-free interest rate: ln(Bt(T )) = rt = lim T t (T t)0

Yuriy Kitsul

n i=0 ai i i (xt ) n i=0 ai i (xt )

(17)

21

Market Price of Risk - 1

Due (2001): assume dMt = M (t)dt + M (t)dWt and consider some arbitrary security, with cumulative-return process, dRt =
dSt St

S (t) St dt

(t) + S St dWt

Then, the Sharpe ratio, or the market price of risk, t: t =

R (t)rt R (t) (t) = M Mt

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22

Market Price of Risk - 2

Using Ito lemma:

n n

dMt = {A(
i=0

aii(xt))}dt + (xt)(
i=0

aii(xt)) dWt

(18)

Therefore, (xt)(
n i=0 ai i (xt )

t =

n i=0 ai i (xt )

(19)

Risk premium is very general and can change sign.

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23

Positivity of Pricing Kernel

Hansen/Richard(87) and Cochrane(2001): M > 0 no-arbitrage. Example of how to impose positivity numerically: - Consider: Mt = a0 + a1H1(xt) + a2H2(xt) - Find a map between the coecients (a0, a1, a2) of this combination of Hermite polynomials and coecients (b, c) of a regular polynomial of the second order that has only complex roots and, thus, never crosses zero: a0 + a1H1(x) + a2H2(x) = (x b ic)(x b + ic) - Mt is either positive or negative on the whole state space of xt. If negative, multiply it by 1. Impose a prior in the process of MCMC estimation.
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Multi-Factor Extension

Independent factors, x1t and x2t, with eigenfunctions 1i and 2j , respectively.

n1 n2

Mt =
i=0 j =0

aij 1i(x1t)2j (x2t)

(20)

Dene ij (xt) = 1i(x1t)2j (x2t), where xt = [x1t, x2t] The following property3 and all the previous results hold: Et{ij (xT )} = eij (T t)ij (xt) where ij = 1i + 2j
3 See Meddahi(2001 a) for details

(21)

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25

Data and Estimation Method

Original and updated versions of a data set of Ahn/Dittmar/Gallant/Gao(03) who combine data of McCulloch and Kwon(93) and data provided by Daniel Wagooner and obtained by methods described in Bliss(97) Range: 01/52 - 12/99 (extended data is available till 12/02). Maturity: 6 months. Method of estimation: Ecient Method of Moments proposed by Gallant and Tauchen(96) and extended in Gallant and Tauchen(04) with Markov Chain Monte Carlo methodology along the lines of Chernozhukov and Hong(2003).

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26

Overview of Ecient Method of Moments (EMM) - 1

Advantages: - Used when likelihood methods are not practical. - Avoids an ad hoc selection of moment conditions when compared to other methods of moments. - Perfect for unobservable/latent factor structures and continuous-time models. Simulation-based method (related to Due and Singleton(93) and Gourieroux, Monfort and Renault(93)): Choose the parameters, , of a model of interest (let us call it the main model) in such a manner that the data simulated from the model is as close to the observed data as possible.
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Overview of Ecient Method of Moments (EMM) - 2

Step 1: Projection: Summarize the data using the so-called auxiliary model, which is not the true model, but which approximates the data suciently well and has a readily computable likelihood function f () in a closed form. Estimate the parameters of the auxiliary model, , by maximizing its likelihood and and using the observed data, y t, x t1: n = arg max 1 n
n yt | x t1, )] t=1 log [f (

where n is the number of observations. Therefore, by construction

1 n n yt | x t1, )] t=1 log [f (

=0

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28

Overview of Ecient Method of Moments (EMM) - 3

Step 2: Estimation: The obtained score vector is used to generate moment conditions by simulating {y t, x t1} from the main model: m(, ) =
1 N N yt | x t1, )] t=1 log [f (

We choose the parameters of the main model, so that the generated moment conditions are as close to zero as possible: n)(I n) n)1m(, n = arg min m (, n is a quasimaximum likelihood information matrix and where I n)(I n) 2 n)1m(, nsn( ) = nm (, dim()dim( )
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Overview of Ecient Method of Moments (EMM) - 4, MCMC Extention

Construct the analog to the likelihood in the Bayesian Markov Chain Monte Carlo (MCMC) methods: L() = ensn() Use the standard Metropolis-Hastings algorithm to simulate a chain (and use its mode as the estimate): {(1), ...., (Nch)}. 1) Easy to impose prior restrictions on non-linear functionals () 2) Much better optimizer than the traditional methods (eg. a hill-climber) 3) Can use an analog of Bayesian posterior for econometric inference.
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Metropolis-Hastings algorithm

A candidate for the next value in the chain, new is drawn from a proposal density q (new |old), which, among other things, is easy to simulate from. Using the candidate value, new the data simulation of length N is obtained and the objective function, sn(new ), the functional of the parameters, new , the prior, (new , new ), and the likelihood, L(new ) = ensn(new ) are computed. The chain moves from old to new with probability
(new ) (new ,new )q (new |old ) min{ LL ( ) ( , )q ( |new ) , 1}
old old old old

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31

Data and Projected Conditional Mean

Data and projected conditional mean, Sixmonth Treasury Bill, 03/53 12/99 18 projected data 16

14

12

percent

10

0 53

58

63

68

73

78 time

83

88

93

98

Figure 1: 6-month Treasure Bill: Data, 03/53-12/99 and conditional mean obtained with 11s1s0s1s1400000 SNP score .

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32

Gaussian Factor Case: Empirical Model and Observation Equation

Factor/state variable dynamics: dxt = ( xt)dt + dWt Pricing kernel within a model with n Hermite polynomials, H (n)-model: Mt = Yield: yldt(T ) = T 1 t {ln(
n i(T t) a e Hi(xt)) i i=0 n i=0 ai Hi (xt )

ln(

n i=0 ai Hi (xt ))}

Estimated parameters: {, , , a1, ...an}.

Yuriy Kitsul 33

Estimation Results: 1 Gaussian factor, 2, 3 and 4 Hermite polynomials, Score: 11s1s0s1s1400000

Coecient/Model

CIR 0.12294 ( 0.072865) 5.1059 (0.092615) 0.19717 (0.0081534)

H(2) 0.40527 (0.048579) 0.081055 (0.036123) 0.16699 (0.021523) 1, xed 1, xed -0.2373 (0.042031)

H(3) 0.73877 (0.051739) 0.19678 (0.049139) 0.2915 (0.021654) 1, xed 1, xed -0.10693 (0.011367) 0.31494 (0.016185)

H(4) 0.604 (0.015484) -0.14795 (0.026694) 0.17139 (0.010689) 1, xed 1, xed -0.23877 (0.0021196) 0.36616 (0.0017625) -0.12256 (0.0016904) 7.308 0.1205 4

a0 a1 a2 a3 a4 2 p value df

21.323 0.0033 7

21.716 0.0014 6

9.9722 0.0760 5

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34

0.2 0.4 0.6 0.8 1.0

10000

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Figure 2: CIR model. Chain of each of the parameters, {, , }. Every 50th point is plotted.
.
Yuriy Kitsul 35

32 30 28 26 24 22

1.0 0.0

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Figure 3: CIR model. Auto-correlation function for each of the parameters, {, , }.

.
Yuriy Kitsul 36

0.0

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Figure 4: CIR model. Kernel density for each of the parameters, {, , }.

.
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V1

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V3

Figure 5: CIR model. Scatter plots of pairs of parameters {, , }. Every 50th point is plotted. .
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0.2 0.5 0.8

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Figure 6: H(2) model. Chain of each of the parameters, {, , , a0, ..., a2}. Note: a0 and a1 are xed for the identication purposes. Every 50th point is plotted. .
Yuriy Kitsul 39

0.0 0.4 0.8

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Figure 7: H(2) model. Auto-correlation function for each of the parameters, {, , , a0, ..., a2}. Note: a0 and a1 are xed for the identication purposes. .
Yuriy Kitsul 40

0.2

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0.5

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0.1

0.0

0.1

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1.0

0.8

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0.2

0.0

0.2

Figure 8: H(2) model. Kernel density for each of the parameters, {, , , a0, ..., a2}. Note: a0 and a1 are xed for the identication purposes. .
Yuriy Kitsul 41

V1

V2

V3

V4

V5

V6

Figure 9: H(2) model. Scatter plots of pairs of parameters {, , , a0, ..., a2}. Note: a0 and a1 are xed for the identication purposes. . Every 50th point is plotted.
Yuriy Kitsul 42

0.50 0.60 0.70

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0.245 0.230 0.6 1.0 1.4 0.6 1.0 1.4 0.14 0.18 0.22 0.20 0.05

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20 14 8 0.130 0.115 0.360 0.370

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Figure 10: H(4) model. Chain of each of the parameters, {, , , a0, ..., a4}. Note: a0 and a1 are xed for the identication purposes. Every 50th point is plotted. .
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0.0 0.4 0.8

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Figure 11: H(4) model. Auto-correlation function for each of the parameters, {, , , a0, ..., a4}. Note: a0 and a1 are xed for the identication purposes. .
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0.0 0.4 0.8

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Figure 12: H(4) model. Kernel density for each of the parameters, {, , , a0, ..., a4}. Note: a0 and a1 are xed for the identication purposes. .
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V1

V2

V3

V4

V5

V6

V7

V8

Figure 13: H(4) model. Scatter plots of pairs of parameters {, , , a0, ..., a4}. Note: a0 and a1 are xed for the identication purposes. . Every 50th point is plotted.
Yuriy Kitsul 46

Projected and reprojected conditional means, Sixmonth Treasury Bill, 03/53 12/99 18 projected reprojected 16

14

12

percent

10

0 53

58

63

68

73

78 time

83

88

93

98

Relative difference between projected and reprojected conditional mean, Sixmonth Treasury Bill, 03/53 12/99 3

percent
1 2 3 4 53

58

63

68

73

78 time

83

88

93

98

Figure 14: Conditional projected and reprojected rst moments and their dierence; 1 Gausssian factor - 4 Hermite polynomials model, estimated using 11s1s0s1s1400000 SNP score.
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Projected and reprojected conditional volatilities, Sixmonth Treasury Bill, 03/53 12/99 7 projected reprojected 6

0 53

58

63

68

73

78 time

83

88

93

98

Relative difference between projected and reprojected conditional volatility, Sixmonth Treasury Bill, 03/53 12/99 80

60

40

percent

20

20

40 53

58

63

68

73

78 time

83

88

93

98

Figure 15: Conditional projected and reprojected second moments and their dierence; 1 Gausssian factor - 4 Hermite polynomials model, estimated using 11s1s0s1s1400000 SNP score.
Yuriy Kitsul 48

Conclusions

It is possible to have a exible diusion framework with no-arbitrage and closed-form bond prices. EMM-MCMC is very well suited to handle our framework, which is highly non-linear, with prior restrictions on non-linear functionals of parameteres A one Gaussian factor model with a sucient, but not overly excessive number of semi-nonparametric terms can not be rejected by the time-series of 6-month to maturity yields data. Further work: t the model to the joint dynamics of several yields of dierent maturities.

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49

Extensions

Incorporate macroeconomic variables. Apply to a multi-country case. Time-varying functional forms. Derivatives.

50