Michael Johannes
The Statistical and Economic Role of Jumps in Continuous-Time Interest Rate Models
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Abstract:
This paper provides an empirical analysis of the role of jumps in continuous-time models of the short rate. Statistically, if jumps are present diffusion models are misspecified and I develop a test to detect jump-induced misspecification. After finding evidence for jumps, I introduce and estimate a nonparametric jump-diffusion model. The results point toward a dominant statistical role for jumps in determining the dynamics of the short rate relative to diffusive components. Estimates of jump times and sizes indicate that jumps serve an interesting economic purpose: they provide a main conduit for information about the macroeconomy to enter the term structure. Finally, I investigate the pricing implications of jumps. While jumps do not appear to have a large impact on the cross-section of bond prices, they do have important implications for interest rate derivatives.