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A Convergence Model of the Term Structure of Interest Rates

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  • Viktors Ajevskis
  • Kristine Vitola

Abstract

This paper develops a convergence model of the term structure of interest rates in context of entering the European Monetary Union (EMU). Compared to other models developed so far in this field, our model specification ensures convergence of the domestic short-term interest rates to the euro area ones. We achieve this convergence by stating that the spread between domestic and euro short-term interest rate follows the Brownian bridge process. We also develop an econometric counterpart of the theoretical model. To tackle the problem of nonstationarity and nonlinearity of the model, we apply the extended Kalman filter for coefficient estimation. Copyright 2010, Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rof/rfn030
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Bibliographic Info

Article provided by European Finance Association in its journal Review of Finance.

Volume (Year): 14 (2010)
Issue (Month): 4 ()
Pages: 727-747

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Handle: RePEc:oup:revfin:v:14:y:2010:i:4:p:727-747

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  1. Favero, Carlo A & Giavazzi, Francesco & Iacone, Fabrizio & Tabellini, Guido, 1997. "Extracting Information from Asset Prices: The Methodology of EMU Calculators," CEPR Discussion Papers 1676, C.E.P.R. Discussion Papers.
  2. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
  3. De Grauwe, Paul, 1996. "Forward Interest Rates as Predictors of EMU," CEPR Discussion Papers 1395, C.E.P.R. Discussion Papers.
  4. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  5. David S. Bates, 1999. "Financial Markets' Assessment of EMU," NBER Working Papers 6874, National Bureau of Economic Research, Inc.
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