Modeling the term structure of interest rates with general diffusion processes: A moment approximation approach

We propose an analytical approximation of the term structure of interest rates under general diffusion processes of the short-rate and state variables. A method of approximating conditional moments as the solution to a system of ordinary differential equations is applied to the pricing of bonds. Numerical experiments based on two illustrative models show that the second-order approximation is accurate for maturities of up to five years and the third-order approximation is effective for longer maturities. We also show the possibility of improving the second-order approximation without much increasing the computational burden. (c) 2008 Elsevier B.V. All rights reserved.