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Explaining the forward interest rate term structure

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Author Info
Andrew Matacz (Science & Finance, Capital Fund Management)
Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management, CEA Saclay;)
Abstract

We 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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Paper provided by Science & Finance, Capital Fund Management in its series Science & Finance (CFM) working paper archive with number 500046.

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Date of creation: Sep 1999
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Publication status: Forthcoming in Risk Magazine
Handle: RePEc:sfi:sfiwpa:500046

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G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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  1. 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, vol. 60(1), pages 77-105, January. [Downloadable!] (restricted)
  2. Carl Chiarella & Oh-Kang Kwon, 1999. "Classes of Interest Rate Models Under the HJM Framework," Research Paper Series 13, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
  3. Andrew Matacz & Jean-Philippe Bouchaud, 1999. "An empirical investigation of the forward interest rate term structure," Science & Finance (CFM) working paper archive 500047, Science & Finance, Capital Fund Management. [Downloadable!]
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