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On Short Rate Processes and Their Implications for Term Structure Movements

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Author Info

  • Schlögl, Erik
  • Daniel Sommer

Abstract

We compare short rate diffusion models with respect to their implications for term structure movements, the plausiblity of which serves us as a criterion for evaluating the models. Analytically for Gauss-Markov models and numerically for a broader collection of models prevalent in the literature, we isolate the deformations of the term structure generated endogenously. Among other analytical tools we use spread options on the forward rate curve as an aggregate measure of term structure shapes across states. On the basis of our analysis we conclude that the Ho/Lee model should be discarded, since it cannot explain the emergence of downward sloping term structures, that the introduction of mean reversion is essential in order to generate downward sloping term structures in any substantial proportion, that the models typically favor upward sloping term structures for short maturities and downward sloping term structures for longer maturities, and that there is a surprisingly strong similarity among many of the models prevalent in the literature. A model which allows arbitrary boundaries for the short rate realizations to be fixed exogenously completes our analysis.

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Bibliographic Info

Paper provided by University of Bonn, Germany in its series Discussion Paper Serie B with number 293.

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Length: pages
Date of creation: Oct 1994
Date of revision:
Handle: RePEc:bon:bonsfb:293

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Postal: Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany
Fax: +49 228 73 6884
Web page: http://www.bgse.uni-bonn.de

Related research

Keywords: arbitrage; term structure of interest rates; spread option pricing;

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References

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  1. Rady, Sven, 1994. "The Direct Approach to Debt Option Pricing," Munich Reprints in Economics 3404, University of Munich, Department of Economics.
  2. Stambaugh, Robert F., 1988. "The information in forward rates : Implications for models of the term structure," Journal of Financial Economics, Elsevier, vol. 21(1), pages 41-70, May.
  3. Hull, John & White, Alan, 1990. "Valuing Derivative Securities Using the Explicit Finite Difference Method," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(01), pages 87-100, March.
  4. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-92.
  5. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  6. Hull, John & White, Alan, 1993. "One-Factor Interest-Rate Models and the Valuation of Interest-Rate Derivative Securities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(02), pages 235-254, June.
  7. Ho, Thomas S Y & Lee, Sang-bin, 1986. " Term Structure Movements and Pricing Interest Rate Contingent Claims," Journal of Finance, American Finance Association, vol. 41(5), pages 1011-29, December.
  8. K. Sandmann & Sondermann, D., 1993. "A Term Structure Model and the Pricing of Interest Rate Derivative," Discussion Paper Serie B 180, University of Bonn, Germany.
  9. K. Sandmann & Sandmann, K., 1995. "The Direct Approach to Debt Option Pricing," Discussion Paper Serie B 212, University of Bonn, Germany.
  10. Flesaker, Bjorn, 1993. "Testing the Heath-Jarrow-Morton/Ho-Lee Model of Interest Rate Contingent Claims Pricing," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(04), pages 483-495, December.
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Cited by:
  1. Schloegl, Erik & Daniel Sommer, 1997. "Factor Models and the Shape of the Term Structure," Discussion Paper Serie B 395, University of Bonn, Germany.

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