Estimation of the Volatility Structure of the Fixed Income Market

This paper considers the dynamics for interest rate processes within the Heath, Jarrow and Morton (1992) specification. It is well known that one of the difficulties in using this specification for estimation is the non-Markovian nature of the dynamics. The paper focuses on a fairly broad family of models that not only can be transformed into a Markovian dynamics, but also has an affine representation for the observed data, which overlaps but is not nested in the Duffie and Kan (1996) class of affine term structure models. The model parameters are estimated using a maximum likelihood function obtained via the local linearization filter proposed by Jimenez and Ozaki (2002, 2003). The method is then applied to analyze the volatility structure of the LIBOR markets