Linear-Rational Term Structure Models

Damir Filipovic, Martin Larsson and Anders Trolle
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Damir Filipovic: EPFL and Swiss Finance Institute
Martin Larsson: EPFL and Swiss Finance Institute
Anders Trolle: EPFL and Swiss Finance Institute

No 14-15, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We introduce the class of linear-rational term structure models, where the state price density is modeled such that bond prices become linear-rational functions of the current state. 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 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.

Keywords: Swaps; Swaptions; Unspanned Factors; Zero Lower Bound (search for similar items in EconPapers)
JEL-codes: E43 G12 G13 (search for similar items in EconPapers)
Pages: 113 pages
Date: 2014-02
New Economics Papers: this item is included in nep-mac
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Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1415

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