One factor models for the term structure of interest rates and their implications for derivative pricing

In the recent literature many different continuous time processes have been proposed as a model for the evolution of short term interest rates. These continuous time processes are particularly attractive because they greatly simplify the pricing of derivative contracts such as bond options, caps and floors. From the econometric point of view, however, processes that are specified in continuous time are not that easy to handle, because the process is typically observed at discrete time-intervals only. The aim of this project is firstly to improve on the estimation of models specified in continuous time using simulation techniques and recently developed estimation procedures such as Efficient Method of Moments of Gallant and Tauchen. Subsequently the aim of the project is to use the estimated process for the short rate as the factor in a one factor model to price bond-derivatives. The limitations of one factor models and extensions to multifactor models will also be considered. Finally the implications of the various models for pricing the options implicit in typical Dutch mortgage contracts could be analyzed.