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A term structure model with level factor cannot be realistic and arbitrage free

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  • Dubecq , S.
  • Gourieroux , C.

Abstract

A large part of the term structure literature interprets the first underlying factors as a level factor, a slope factor, and a curvature factor. In this paper we consider factor models interpretable as a level factor model, a level and a slope factor model, respectively. We prove that such models are compatible with no-arbitrage restrictions and the positivity of rates either under rather unrealistic conditions on the dynamic of the short term interest rate, or at the cost of explosive long-term interest rates. This introduces some doubt on the relevance of the level and slope interpretations of factors in term structure models.

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Bibliographic Info

Paper provided by Banque de France in its series Working papers with number 359.

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Length: 36 pages
Date of creation: 2012
Date of revision:
Handle: RePEc:bfr:banfra:359

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Related research

Keywords: Interest Rate; Term Structure; Affine Model; No Arbitrage; Level Factor; Slope Factor.;

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