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A two-mean reverting-factor model of the term structure of interest rates

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  • Manuel Moreno

Abstract

This 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.

Suggested Citation

  • Manuel Moreno, 1996. "A two-mean reverting-factor model of the term structure of interest rates," Economics Working Papers 193, Department of Economics and Business, Universitat Pompeu Fabra.
    • Handle: RePEc:upf:upfgen:193
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    Cited by:

    1. Lourdes Gómez-Valle & Julia Martínez-Rodríguez, 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.
    2. Fernando Rubio, 2004. "Eficiencia Simple Del Mercado De Renta Fija En Chile," Finance 0405009, University Library of Munich, Germany.
    3. Tarik Bazgour & Federico Platania, 2022. "A defaultable bond model with cyclical fluctuations in the spread process," Annals of Operations Research, Springer, vol. 312(2), pages 647-672, May.

    More about this item

    Keywords

    Term structure of interest rates; bond pricing equation; two--factor models; Ornstein--Uhlenbeck processes; interest rate derivatives;
    All these keywords.

    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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