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Fundamental Properties of Bond Prices in Models of the Short-Term Rate

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  • Antonio Mele

    (Queen Mary, University of London)

Abstract

This paper develops restrictions that arbitrage-constrained bond prices impose on the short-term rate process in order to be consistent with given dynamic properties of the term-structure of interest rates. The central focus is the relationship between bond prices and the short-term rate volatility. In both scalar and multidimensional diffusion settings, typical relationships between bond prices and volatility are generated by joint restrictions on the risk-neutralized drift functions of the state variables and convexity of bond prices with respect to the short-term rate. The theory is illustrated by several examples and is partially extended to accommodate the occurrence of jumps and default.

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Paper provided by Queen Mary, University of London, School of Economics and Finance in its series Working Papers with number 460.

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Date of creation: Jun 2002
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Handle: RePEc:qmw:qmwecw:wp460

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Cited by:
  1. Lioui, Abraham, 2007. "The asset allocation puzzle is still a puzzle," Journal of Economic Dynamics and Control, Elsevier, vol. 31(4), pages 1185-1216, April.
  2. Antonio Mele, 2004. "General properties of rational stock-market fluctuations," LSE Research Online Documents on Economics 24701, London School of Economics and Political Science, LSE Library.
  3. Xavier Gabaix, 2007. "Linearity-Generating Processes: A Modelling Tool Yielding Closed Forms for Asset Prices," NBER Working Papers 13430, National Bureau of Economic Research, Inc.
  4. Mele, Antonio, 2007. "Asymmetric stock market volatility and the cyclical behavior of expected returns," Journal of Financial Economics, Elsevier, vol. 86(2), pages 446-478, November.

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