Modelling the Yield Curve: A Two Components Approach
AbstractUsing parametric return autocorrelation tests and non parametric variance ratio statistics show that the UK and US short-term interest rates are unit root processes with significant mean reverting components. Congruent with this empirical evidence, we develop a new continuous time term structure model which assumes that the dynamics of the instantaneous interest rate are given by the joint effect of a (stationary) mean reverting component and a (nonstationary) martingale component. We provide a closed-form solution for the equilibrium yield curve when the temporary component is modelled as an Ornstein-Uhlenbeck process and the permanent component is modelled as an Arithmetic Brownian motion process.
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Bibliographic InfoPaper provided by Queen Mary, University of London, School of Economics and Finance in its series Working Papers with number 519.
Date of creation: Sep 2004
Date of revision:
Term structure; Mean reversion; Random walk; Brownian motion; Variance ratio; Linear regression;
Find related papers by JEL classification:
- C20 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - General
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
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