Factor Models and the Shape of the Term Structure
Abstracthe present paper analyses a broad range of one- and multifactor models of the term structure of interest rates. We assess the influence of the number of factors, mean reversion, and the factor probability distributions on the term structure shapes the models generate, and use spread options as an aggregate measure of the relative importance assigned to rising and falling forward rate curves by the models considered. We derive valuation formulas for these contingent claims in the multifactor Gaussian and CIR-models. Our main result is that the specification of mean reversion and the number of factors are both much more important for the relative movements of interest rates than the distributional characteristics of the factors. To the extent that interest rate risk depends on the movements of different parts of the term structure relative to one another rather than on shifts of its absolute level, the distributional assumption on the factor dynamics is found to be essentially irrelevant.
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Bibliographic InfoPaper provided by University of Bonn, Germany in its series Discussion Paper Serie B with number 395.
Date of creation: Jan 1997
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multifactor term structure models; spread options; term structure shapes; forward rate curves; mean reversion;
Find related papers by JEL classification:
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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