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Dynamics of the term structure on interest rates: a two-factor model

Author

Listed:
  • Hortensia Fontanals Albiol
  • Merche Galisteo
  • Lourdes Gomez del Valle

    (Universitat de Barcelona)

Abstract

The main goal of this paper is to develop a model of the term structure of interest rates, based on a Black-Sholes type of arbitrage and study its properties. In order to achieve this objective two state variables are considered: the long-term interest rate l(t), and the spread (difference between the instantaneous and the long-term interest rat), s(t). These two state variables have been previously considered by other researchers: Shaefer and Schwartz (1984) and Moreno (1997). The main differences of this paper from Schaefer and Schwartz's consist on defining l(t) as the long-term interest rate (Schaefer and Schwartz used the consol rate). As a result, the market price of risk associated to this variable is an exogenous parameter of the model. In comparison to Moreno's in this paper the long-term interest rate follows a square root process which does not allow negative rates and the volatility is sensitive to the variations of the process.

Suggested Citation

  • Hortensia Fontanals Albiol & Merche Galisteo & Lourdes Gomez del Valle, 1998. "Dynamics of the term structure on interest rates: a two-factor model," Working Papers in Economics 37, Universitat de Barcelona. Espai de Recerca en Economia.
  • Handle: RePEc:bar:bedcje:199837
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    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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