RFS Advance Access originally published online on February 10, 2005
Review of Financial Studies 2005 18(2):707-742; doi:10.1093/rfs/hhi018
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Jackknifing Bond Option Prices
Cowles Foundation for Research in Economics, Yale University, University of Auckland and University of York
University of Auckland and Singapore Management University
Address correspondence to: Jun Yu, School of Economics and Social Sciences, Singapore Management University, 469 Bukit Timah Road, Singapore, 259756, Tel.: +65 6822 0858, or e-mail: yujun{at}smu.edu.sg
Prices of interest rate derivative securities depend crucially on the mean reversion parameters of the underlying diffusions. These parameters are subject to estimation bias when standard methods are used. The estimation bias can be substantial even in very large samples and much more serious than the discretization bias, and it translates into a bias in pricing bond options and other derivative securities that is important in practical work. This article proposes a very general and computationally inexpensive method of bias reduction that is based on Quenouille's (1956; Biometrika, 43, 353–360) jackknife. We show how the method can be applied directly to the options price itself as well as the coefficients in the models. We investigate its performance in a Monte Carlo study. Empirical applications to U.S. dollar swap rates highlight the differences between bond and option prices implied by the jackknife procedure and those implied by the standard approach. These differences are large and suggest that bias reduction in pricing options is important in practical applications.