Modelling the Yield Curve: A Two Components Approach

John Hatgioannides, Menelaos Karanasos and Marika Karanassou
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John Hatgioannides: City University
Menelaos Karanasos: University of York
Marika Karanassou: Queen Mary, University of London

No 519, Working Papers from Queen Mary University of London, School of Economics and Finance

Abstract: Using parametric return autocorrelation tests and non parametric variance ratio statistics show that the UK and US short-term interest rates are unit root processes with significant mean reverting components. Congruent with this empirical evidence, we develop a new continuous time term structure model which assumes that the dynamics of the instantaneous interest rate are given by the joint effect of a (stationary) mean reverting component and a (nonstationary) martingale component. We provide a closed-form solution for the equilibrium yield curve when the temporary component is modelled as an Ornstein-Uhlenbeck process and the permanent component is modelled as an Arithmetic Brownian motion process.

Keywords: C20; E43; G12 (search for similar items in EconPapers)
JEL-codes: C20 E43 G12 (search for similar items in EconPapers)
Date: 2004-09-01
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Persistent link: https://EconPapers.repec.org/RePEc:qmw:qmwecw:519

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