Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model

We develop a two-factor general equilibrium model of the term structure. The factors are the short-term interest rate and the volatility of the short-term interest rate. We derive closed-form expressions for discount bonds and study the properties of the term structure implied by the model. The depe...

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Bibliographic Details
Published in:The Journal of finance (New York) 1992-09, Vol.47 (4), p.1259-1282
Main Authors: LONGSTAFF, FRANCIS A., SCHWARTZ, EDUARDO S.
Format: Article
Language:English
Subjects:
Bond market
Bonds
Contingent claims
Discounts
Economic models
Economic theory
Financial bonds
Financial economics
Financial instruments
General economic equilibrium
Generalized method of moments
Interest rates
Mathematical models
Price volatility
Studies
Volatility
Yield
Yield curves
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Summary:We develop a two-factor general equilibrium model of the term structure. The factors are the short-term interest rate and the volatility of the short-term interest rate. We derive closed-form expressions for discount bonds and study the properties of the term structure implied by the model. The dependence of yields on volatility allows the model to capture many observed properties of the term structure. We also derive closed-form expressions for discount bond options. We use Hansen's generalized method of moments framework to test the cross-sectional restrictions imposed by the model. The tests support the two-factor model.
ISSN:0022-1082
1540-6261
DOI:10.1111/j.1540-6261.1992.tb04657.x