A cyclical square-root model for the term structure of interest rates

Manuel Moreno and Federico Platania

European Journal of Operational Research, 2015, vol. 241, issue 1, 109-121

Abstract: This paper presents a cyclical square-root model for the term structure of interest rates assuming that the spot rate converges to a certain time-dependent long-term level. This model incorporates the fact that the interest rate volatility depends on the interest rate level and specifies the mean reversion level and the interest rate volatility using harmonic oscillators. In this way, we incorporate a good deal of flexibility and provide a high analytical tractability. Under these assumptions, we compute closed-form expressions for the values of different fixed income and interest rate derivatives. Finally, we analyze the empirical performance of the cyclical model versus that proposed in Cox et al. (1985) and show that it outperforms this benchmark, providing a better fitting to market data.

Keywords: Square-root process; Interest rates; Continuous-time model; Harmonic waves; Martingale (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (17)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:241:y:2015:i:1:p:109-121

DOI: 10.1016/j.ejor.2014.08.010

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