Modelling the Yield Curve: A Two Components Approach

John Hatgioannides, Menelaos Karanasos () and Marika Karanassou ()
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John Hatgioannides: City University

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: Term structure; Mean reversion; Random walk; Brownian motion; Variance ratio; Linear regression (search for similar items in EconPapers)
JEL-codes: C20 E43 G12 (search for similar items in EconPapers)
Date: 2004-09
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