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Risk management under a two-factor model of the term structure of interest rates


  • Manuel Moreno


This paper presents several applications to interest rate risk management based on a two-factor continuous-time model of the term structure of interest rates previously presented in Moreno (1996). This model assumes 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). Several new measures of ``generalized duration" are presented and applied in different situations in order to manage market risk and yield curve risk. By means of these measures, we are able to compute the hedging ratios that allows us to immunize a bond portfolio by means of options on bonds. Focusing on the hedging problem, it is shown that these new measures allow us to immunize a bond portfolio against changes (parallel and/or in the slope) in the yield curve. Finally, a proposal of solution of the limitations of conventional duration by means of these new measures is presented and illustrated numerically.

Suggested Citation

  • Manuel Moreno, 1997. "Risk management under a two-factor model of the term structure of interest rates," Economics Working Papers 254, Department of Economics and Business, Universitat Pompeu Fabra.
  • Handle: RePEc:upf:upfgen:254

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    Cited by:

    1. SerafĂ­n Frache & Gabriel Katz, 2004. "Estimating a Risky Term Structure of Uruguayan Sovereign Bonds," Documentos de Trabajo (working papers) 0304, Department of Economics - dECON.

    More about this item


    Term structure of interest rates; two-factor models; measures of generalized duration; hedging ratios; interest rate risk;

    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
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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