Marti G Subrahmanyam, Richard C Stapleton
ABSTRACT
In this paper we investigate models of the term structure where the
factors are interest rates. As an example, we derive a no-arbitrage model
of the term structure in which any two futures (as opposed to forward)
rates act as factors. The term structure shifts and tilts as the factor
rates vary. The cross-sectional properties of the model derive from the
solution of a two-dimensional autoregressive process for the short rate,
which exhibits mean reversion and a lagged memory parameter. We show that
the correlation of the factor rates is restricted by the no-arbitrage conditions
of the model. Hence in a multiple-factor model it is not valid to independently
choose both the mean reversion, volatility and correlation parameters,
contrary to the approach of some models in the literature. The term-structure
model, derived here, can be used to value options on bonds and swaps or
to generate term structure scenarios for the risk management of portfolios
of interest-rate derivatives.
Subrahmanyam: (212) 998-0348 msubrahma@stern.nyu.edu
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