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Linear‐Rational Term Structure Models
Author(s) -
FILIPOVIĆ DAMIR,
LARSSON MARTIN,
TROLLE ANDERS B.
Publication year - 2017
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12488
Subject(s) - interest rate derivative , rational expectations , forward rate , interest rate , volatility (finance) , econometrics , term (time) , yield curve , libor market model , interest rate swap , mathematics , class (philosophy) , heath–jarrow–morton framework , economics , mathematical economics , computer science , finance , artificial intelligence , physics , quantum mechanics
We introduce the class of linear‐rational term structure models in which the state price density is modeled such that bond prices become linear‐rational functions of the factors. This class is highly tractable with several distinct advantages: (i) ensures nonnegative interest rates, (ii) easily accommodates unspanned factors affecting volatility and risk premiums, and (iii) admits semi‐analytical solutions to swaptions. A parsimonious model specification within the linear‐rational class has a very good fit to both interest rate swaps and swaptions since 1997 and captures many features of term structure, volatility, and risk premium dynamics—including when interest rates are close to the zero lower bound.