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Modelling the Yield Curve: A Two Components Approach

Author

Listed:
  • John Hatgioannides

    (City University)

  • Menelaos Karanasos

    (University of York)

  • Marika Karanassou

    (Queen Mary, University of London)

Abstract

Using parametric return autocorrelation tests and non parametric variance ratio statistics show that the UK and US short-term interest rates are unit root processes with significant mean reverting components. Congruent with this empirical evidence, we develop a new continuous time term structure model which assumes that the dynamics of the instantaneous interest rate are given by the joint effect of a (stationary) mean reverting component and a (nonstationary) martingale component. We provide a closed-form solution for the equilibrium yield curve when the temporary component is modelled as an Ornstein-Uhlenbeck process and the permanent component is modelled as an Arithmetic Brownian motion process.

Suggested Citation

  • John Hatgioannides & Menelaos Karanasos & Marika Karanassou, 2004. "Modelling the Yield Curve: A Two Components Approach," Working Papers 519, Queen Mary University of London, School of Economics and Finance.
    • Handle: RePEc:qmw:qmwecw:519
    as

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    File URL: https://www.qmul.ac.uk/sef/media/econ/research/workingpapers/2004/items/wp519.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    C20; E43; G12;
    All these keywords.

    JEL classification:

    • C20 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - General
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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