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RFS Advance Access published online on February 10, 2005
Review of Financial Studies, doi:10.1093/rfs/hhi018
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The Review of Financial Studies © The Author 2005. Published by Oxford University Press on behalf of the Society of for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oupjournals.org

Original Articles

Jackknifing Bond Option Prices*

Peter C. B. Phillips 1 and Jun Yu 2*
1 Cowles Foundation for Research in Economics, Yale University; Cowles Foundation for Research in Economics, University of Auckland; Cowles Foundation for Research in Economics, University of York
2 University of Auckland; Singapore Management University

* To whom correspondence should be addressed.
Jun Yu, E-mail: yujun{at}smu.edu.sg


  Abstract

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. The present paper proposes a very general and computationally inexpensive method of bias reduction that is based on Quenouille's (1956) 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.

*We thank Ken Singleton (the editor), an anonymous referee, Torben Andersen, Federico Bandi, Henk Berkman, Charles Corrado, Jin-chuan Duan, Tony Hall, Shirley Huang, John Knight, Steve Satchell, Yiu Kuen Tse, and seminar participants at Yale University, Queen's University, University of Auckland, Singapore Management University, Simon Fraser University, University of Technology, Sydney, the 2003 New Zealand Econometric Study Group Meetings in Auckland, the 7th New Zealand Finance Colloquium, the 2003 Canadian Econometric Study Group Meeting, the 2004 North American Winter Meeting of Econometric Society for helpful discussions. Phillips thanks the NSF for support under Grant No. SES 00-92509. Yu gratefully acknowledges financial support from the Royal Society of New Zealand Marsden Fund under No. 01-UOA-015 and the Cowles Foundation at Yale University for hospitality during a visit over the period from October 2002 to November 2002.


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