Explaining the forward interest rate term structure
AbstractWe present compelling empirical evidence for a new interpretation of the Forward Rate Curve (FRC) term structure. We find that the average FRC follows a square-root law, with a prefactor related to the spot volatility, suggesting a Value-at-Risk like pricing. We find a striking correlation between the instantaneous FRC and the past spot trend over a certain time horizon. This confirms the idea of an anticipated trend mechanism proposed earlier and provides a natural explanation for the observed shape of the FRC volatility. We find that the one-factor Gaussian Heath-Jarrow-Morton model calibrated to the empirical volatility function fails to adequately describe these features.
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Bibliographic InfoPaper provided by Science & Finance, Capital Fund Management in its series Science & Finance (CFM) working paper archive with number 500046.
Date of creation: Sep 1999
Date of revision:
Publication status: Forthcoming in Risk Magazine
Find related papers by JEL classification:
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
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- Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, Econometric Society, vol. 60(1), pages 77-105, January.
- Carl Chiarella & Oh-Kang Kwon, 1999. "Classes of Interest Rate Models Under the HJM Framework," Research Paper Series, Quantitative Finance Research Centre, University of Technology, Sydney 13, Quantitative Finance Research Centre, University of Technology, Sydney.
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