A two-mean reverting-factor model of the term structure of interest rates
AbstractThis paper presents a two--factor model of the term structure of interest rates. We assume that default free discount bond prices are determined by the time to maturity and two factors, the long--term interest rate and the spread (difference between the long--term rate and the short--term (instantaneous) riskless rate). Assuming that both factors follow a joint Ornstein--Uhlenbeck process, a general bond pricing equation is derived. We obtain a closed--form expression for bond prices and examine its implications for the term structure of interest rates. We also derive a closed--form solution for interest rate derivatives prices. This expression is applied to price European options on discount bonds and more complex types of options. Finally, empirical evidence of the model's performance is presented.
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Bibliographic InfoPaper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 193.
Date of creation: Nov 1996
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Web page: http://www.econ.upf.edu/
Term structure of interest rates; bond pricing equation; two--factor models; Ornstein--Uhlenbeck processes; interest rate derivatives;
Find related papers by JEL classification:
- C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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- Fernando Rubio, 2004. "Eficiencia Simple Del Mercado De Renta Fija En Chile," Finance 0405009, EconWPA.
- Lourdes Gómez-Valle & Julia Mart�nez-Rodr�guez, 2010. "Improving the term structure of interest rates: two-factor models," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 15(3), pages 275-287.
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