Modeling interest rates moving in a band

Özel, Özgür
It is not uncommon to observe interest rates or currencies to move in a band or being subject to an upper and/or lower bound set by national central banks. The Turkish Central Bank is using the interest rate corridor system actively in tandem with the liquidity policy to fine–tune the short rate in the TRY money market. Bond pricing models relying on a single factor use the short rate as the sole determinant of the entire yield curve. It would be a big mistake to ignore the fact that the short rate in Turkey is moving in a corridor, while pricing bonds using the short rate as the single factor. In this work, we try to establish a one factor yield curve model, where the interest rate is modeled as Vasicek process. The closed-form bond price is the main contribution of the novel approach devised in the thesis. Furthermore, mean reversion and normality tests of the time series justifies the usage of Vasicek process as the underlying interest rate mode