Chapter

Multi‐Factor Diffusion Models

Claus Munk

in Fixed Income Modelling

Published in print June 2011 | ISBN: 9780199575084
Published online September 2011 | e-ISBN: 9780191728648 | DOI: http://dx.doi.org/10.1093/acprof:oso/9780199575084.003.0008
Multi‐Factor Diffusion Models

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The one-factor models of the preceding chapter are not flexible enough to match all the shapes and movements of the yield curve seen in the data. Several empirical studies conclude that two or three factors are needed. This chapter develops multi-factor diffusion models of the term structure. Special attention is given to two-factor versions of the models of Vasicek and Cox, Ingersoll, and Ross (the so-called Longstaff–Schwartz model) in which pricing formulas for bonds and bond options are derived. Generalized affine multi-factor models, quadratic models, and models with unspanned stochastic volatility are also discussed.

Keywords: affine model; model categorization; two-factor Vasicek model; Longstaff–Schwartz model; three-factor models; essentially affine; extended affine; quadratic model; unspanned stochastic volatility

Chapter.  17961 words.  Illustrated.

Subjects: Financial Markets

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