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Explaining the forward interest rate term structure

  • Andrew Matacz

    (Science & Finance, Capital Fund Management)

  • Jean-Philippe Bouchaud

    (Science & Finance, Capital Fund Management
    CEA Saclay;)

Registered author(s):

    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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    1. 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.
    2. 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.
    3. 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.
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