An empirical test of the Brennan-Schwartz bond pricing model in the Australian context

This paper presents an empirical test of some aspects of the Brennan and Schwartz arbitrage bond pricing model. Specifically it evaluates the assumed discrete version of the joint interest process for the short and long rates by estimating it for a series of sample periods under varying market conditions. The implications of the specified form of these two interest rates within the context of hypotheses of interest rate behaviour are also examined. The bond valuation model is tested for bond price index data. The model is found to have a consistent estimation error of 10% and predominantly overestimated the actual price index. The performance of the model is not found to be sensitive to the value of the utility dependent parameter.We thank seminar participants at the University of New South Wales, the Australian National University, and participants at the Inaugural International Conference on Asian-Pacific Financial Markets, November 16–18, 1989, the National University of Singapore for many helpful comments and suggestions. We are responsible for any remaining errors.