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The Statistical and Economic Role of Jumps in Continuous-Time Interest Rate Models

Authors

  • Michael Johannes

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    • Johannes is with the Finance and Economics Division, Graduate School of Business, Columbia University. This is a revised version of my Ph.D. dissertation at the University of Chicago. I thank Torben Andersen, Federico Bandi, John Cook, Pete Kyle, Nick Polson, Pietro Veronesi, Brian Viard, and seminar participants at Cirano/University of Montreal, Columbia, Duke, Northwestern, Chicago, and the Board of Governors of the Federal Reserve for their comments. I would especially like to thank my dissertation committee: Lars Hansen, John Cochrane, and José Scheinkman. The comments of the Editor and the anonymous referees led to significant improvements. All errors are mine.

ABSTRACT

This paper analyzes the role of jumps in continuous-time short rate models. I first develop a test to detect jump-induced misspecification and, using Treasury bill rates, find evidence for the presence of jumps. Second, I specify and estimate a nonparametric jump-diffusion model. Results indicate that jumps play an important statistical role. Estimates of jump times and sizes indicate that unexpected news about the macroeconomy generates the jumps. Finally, I investigate the pricing implications of jumps. Jumps generally have a minor impact on yields, but they are important for pricing interest rate options.

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