Bond and option prices with permanent shocks

Abstract

I develop and estimate an affine short-rate model that incorporates a nonstationary stochastic mean. In my model, the time-varying stochastic mean is subject to a sequence of permanent shocks that can better capture the source of nonlinearity in the drift than existing models. I find that the proposed model provides a better in-sample and out-of-sample fit to observed interest rates and bond prices relative to extant models. More specifically, my model outperforms constant elasticity of volatility models. It follows that the nonstationary stochastic mean model offers new insights to the implied bond option valuation and accounts for the downward bias in bond option prices generally documented in the literature.