| Abstract: | This article proposes a semiparametric two-factor term structuremodel based on a consol rate and the spread between a shortrate and the consol rate. The diffusion functions in both theconsol rate and spread processes are nonparametrically specifiedso that the model allows for maximal flexibility of diffusionfunctions in fitting into data. The drift function of the spreadprocess is specified as a mean-reverting function, while thedrift function of the consol rate process is left unrestricted.A nonparametric procedure is developed for estimating the diffusionfunctions. The asymptotic biases of the nonparametric estimatorsare quantified when the step of discretization is fixed, whilethe asymptotic distributions of the nonparametric estimatorsare derived when the step of discretization tends to zero. Thepricing and hedging performances of the model are evaluatedin a simulated economic environment. Results show that the modelperforms quite well in the simulated economy. |
