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Term Structure of Interest Rates and Implied Market Frictions: The Min--Max Approach

Author

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  • Ioulia D. Ioffe

    (Carlson School of Management, University of Minnesota, 321 19th Avenue South, Minneapolis, Minnesota 55455)

  • Eliezer Z. Prisman

    (Schulich School of Business, York University, 4700 Keele Street, Toronto, Ontario, Canada M3J 1P3)

Abstract

It is often assumed that financial markets are frictionless. Bond markets are illiquid and bond prices are observed with errors. The magnitude of these errors leads to violation of no--arbitrage conditions and, consequently, prevents researchers from obtaining an estimate of the term structure (TS) of interest rates. Researchers have had to settle for a second--best estimate of the TS (e.g., obtained via regression) at a cost of an economically unrealistic assumption of symmetric market frictions. The true shape of market frictions, however, is not known and generally is a highly complex issue. A no--arbitrage--based methodology that avoids making detrimental assumptions is developed here. It facilitates empirical investigation of the shape of the market frictions and of the TS that are simultaneously imputed from market data assuming "efficient" market frictions that minimize the maximum net arbitrage. The empirical investigation performed in the Canadian and U.S. markets shows that in both markets the frictions are asymmetric and the estimates of the TS produced via regression and our methodology significantly differ.

Suggested Citation

  • Ioulia D. Ioffe & Eliezer Z. Prisman, 2003. "Term Structure of Interest Rates and Implied Market Frictions: The Min--Max Approach," Management Science, INFORMS, vol. 49(7), pages 965-978, July.
  • Handle: RePEc:inm:ormnsc:v:49:y:2003:i:7:p:965-978
    DOI: 10.1287/mnsc.49.7.965.16379
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    References listed on IDEAS

    as
    1. Ross, Stephen A, 1987. "Arbitrage and Martingales with Taxation," Journal of Political Economy, University of Chicago Press, vol. 95(2), pages 371-393, April.
    2. Prisman, Eliezer Z., 1990. "A Unified Approach to Term Structure Estimation: A Methodology for Estimating the Term Structure in a Market with Frictions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(1), pages 127-142, March.
    3. Rubinstein, Mark, 1994. "Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
    4. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
    5. repec:bla:jfinan:v:53:y:1998:i:2:p:499-547 is not listed on IDEAS
    6. Prisman, Eliezer Z, 1986. "Valuation of Risky Assets in Arbitrage Free Economies with Frictions," Journal of Finance, American Finance Association, vol. 41(3), pages 545-557, July.
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    Cited by:

    1. Gzyl, Henryk & Mayoral, Silvia, 2016. "Determination of zero-coupon and spot rates from treasury data by maximum entropy methods," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 456(C), pages 38-50.
    2. Lazar Fred & Prisman Eliezer Z., 2012. "Constructing Historical Yield Curves from Very Sparse Spot Rates: A Methodology and Examples from the 1920s Canadian Market," Journal of Business Valuation and Economic Loss Analysis, De Gruyter, vol. 7(1), pages 1-24, May.

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