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Dynamics of the term structure on interest rates: a two-factor model

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  • Hortensia Fontanals Albiol
  • Merche Galisteo
  • Lourdes Gomez del Valle

    (Universitat de Barcelona)

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    Abstract

    The main goal of this paper is to develop a model of the term structure of interest rates, based on a Black-Sholes type of arbitrage and study its properties. In order to achieve this objective two state variables are considered: the long-term interest rate l(t), and the spread (difference between the instantaneous and the long-term interest rat), s(t). These two state variables have been previously considered by other researchers: Shaefer and Schwartz (1984) and Moreno (1997). The main differences of this paper from Schaefer and Schwartz's consist on defining l(t) as the long-term interest rate (Schaefer and Schwartz used the consol rate). As a result, the market price of risk associated to this variable is an exogenous parameter of the model. In comparison to Moreno's in this paper the long-term interest rate follows a square root process which does not allow negative rates and the volatility is sensitive to the variations of the process.

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    Bibliographic Info

    Paper provided by Universitat de Barcelona. Espai de Recerca en Economia in its series Working Papers in Economics with number 37.

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    Length: 0 pages
    Date of creation: 1998
    Date of revision:
    Handle: RePEc:bar:bedcje:199837

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    Postal: Espai de Recerca en Economia, Facultat de Ciències Econòmiques. Tinent Coronel Valenzuela, Num 1-11 08034 Barcelona. Spain.
    Web page: http://www.ere.ub.es
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