• ISSN: 2010-023X
    • Frequency: Bimonthly
    • DOI: 10.18178/IJTEF
    • Editor-in-Chief: Prof.Tung-Zong (Donald) Chang
    • Executive Editor: Ms. Cherry L. Chen
    • Abstracting/ Indexing:  ProQuest, Crossref, Electronic Journals Library , EBSCO, and Ulrich's Periodicals Directory
    • E-mail: ijtef@ejournal.net
IJTEF 2018 Vol.9(2): 54-59 ISSN: 2010-023X
DOI: 10.18178/ijtef.2018.9.2.588

Using the Hidden Markov Model to Improve the Hull-White Model for Short Rate

Nguyet Nguyen, Dung Nguyen, and Thomas P. Wakefield
Abstract—We report a modeling study of short term interest rates using the Hidden Markov Model (HMM) and the Hull-White (HW) model. For this purpose, we modify the original HW model by adding a regime variable to its instantaneous forward function. This variable is defined by the regimes of the short term interest rate which are found by a two-state HMM. The combination of the HMM and the HW model for generating interest rate predictions results in a significant improvement, reducing the error of the estimations by about 50% compared to that of using HW alone. Furthermore, the errors of the simulations using HMM and HW have a smaller standard deviation compare with which of using the HW. Adjusted R-square results also show that the regime variable is significant. This improvement to the short-term interest rate model has a substantial impact on financial economics and related fields.

Index Terms—Interest rate, Hidden Markov Model, simulations, Hull-White, forward rate, regimes.

Nguyet Nguyen and Thomas Wakefield are with the Youngstown State University, Youngstown, Ohio, 44555, USA (e-mail: ntnguyen01@ysu.edu, tpwakefield@ysu.edu).
Dung Nguyen is with the Ned Davis Research Group, Venice, Florida, USA (e-mail dung@ndr.com).

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Cite: Nguyet Nguyen, Dung Nguyen, and Thomas P. Wakefield, "Using the Hidden Markov Model to Improve the Hull-White Model for Short Rate," International Journal of Trade, Economics and Finance vol.9, no.2, pp. 54-59, 2018.

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