Modelling the Yield Curve: A Two Components Approach
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
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)
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