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An Alternative Interest Rate Term Structure Model

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Abstract

This paper proposes analternative approach to the modeling of the interest rate term structure. It suggests that the total market price for risk is an important factor that has to be modeled carefully. The growth optimal portfolio, which is characterized by this factor, is used as refernce unit or benchmark for obtaining a consistent price system. Benchmarked derivative prices are taken as conditional expectations of future benchmarked prices under the real world probability measure. The inverse of the squared total market price for risk is modeled as a square root process and shown to influence the medium and long term forward rates. With constant parameters and constant short rate the model already generates a hump shaped mean of the forward rate curve and other empirical features typically observed.

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File URL: http://www.business.uts.edu.au/qfrc/research/research_papers/rp97.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 97.

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Date of creation: 01 Jun 2003
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Handle: RePEc:uts:rpaper:97

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Keywords: interest rate term structure; growth optimal portfolio; fair pricing; total market price for risk; square root process;

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Cited by:
  1. Shane Miller & Eckhard Platen, 2004. "A Two-Factor Model for Low Interest Rate Regimes," Asia-Pacific Financial Markets, Springer, vol. 11(1), pages 107-133, March.
  2. El Qalli Yassine, 2009. "Term Structure Equations Under Benchmark Framework," EERI Research Paper Series EERI_RP_2009_13, Economics and Econometrics Research Institute (EERI), Brussels.
  3. Nicola Bruti-Liberati & Christina Nikitopoulos-Sklibosios & Eckhard Platen & Erik Schlogl, 2009. "Alternative Defaultable Term Structure Models," Research Paper Series 242, Quantitative Finance Research Centre, University of Technology, Sydney.
  4. Shane M. Miller & Eckhard Platen, 2008. "Analytic Pricing Of Contingent Claims Under The Real-World Measure," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(08), pages 841-867.
  5. Hardy Hulley & Shane Miller & Eckhard Platen, 2005. "Benchmarking and Fair Pricing Applied to Two Market Models," Research Paper Series 155, Quantitative Finance Research Centre, University of Technology, Sydney.

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