Linear-Rational Term Structure Models
Damir Filipovic
Swiss Finance Institute
Ecole Polytechnique FEdErale de Lausanne, Switzerland
Wednesday, March 12, 2014
4:15 - 5:15 PM
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 non-negative interest rates, ii) easily accommodates unspanned factors affecting volatility and risk premia, and iii) admits analytical solutions to swaptions. For comparison, affine term structure models can match either i) or ii), but not both simultaneously, and never iii). A parsimonious specification of the model with three term structure factors and one, or possibly two, unspanned factors has a very good fit to both interest rate swaps and swaptions since 1997. In particular, the model captures well the dynamics of the term structure and volatility during the recent period of near-zero interest rates.
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