Arbitrage-Free Linear Price Function Models for the Term Structure of Interest Rates

• Activity Number: 131
• Type: Contributed
• Date/Time: Monday, August 2, 2010 : 8:30 AM to 10:20 AM
• Sponsor: Business and Economic Statistics Section
• Author(s): Andrew F. Siegel*+
• Companies: University of Washington
• Keywords: Term Structure ; Interest Rates ; Yields ; Bonds ; Linear Price Model

Abstract

The arbitrage-free term structure models introduced here are structurally less constrained than affine models, and the differential equation admits a closed-form solution in the general case. Compatible specification of conditional stochastic volatility and correlation for the state variables is very general because the constraint imposed by the no-arbitrage condition is satisfied entirely by the drift term of the stochastic differential equation, allowing essentially any mean-zero volatility specification. A specific submodel within this family is identified that produces yield curves that closely match the widely-used (but not arbitrage-free) parsimonious models introduced by Nelson and Siegel in 1987.