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An Alternative Interest Rate Term Structure Model

Author

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  • ECKHARD PLATEN

    (University of Technology Sydney, School of Finance & Economics and Department of Mathematical Sciences, PO Box 123, Broadway, NSW, 2007, Australia)

Abstract

This paper proposes an alternative approach to the modeling of the interest rate term structure. It suggests that the total market price for risk is an important factor that has to be modeled carefully. The growth optimal portfolio, which is characterized by this factor, is used as reference unit or benchmark for obtaining a consistent price system. Benchmarked derivative prices are taken as conditional expectations of future benchmarked prices under the real world probability measure. The inverse of the squared total market price for risk is modeled as a square root process and shown to influence the medium and long term forward rates. With constant parameters and constant short rate the model already generates a hump shaped mean for the forward rate curve and other empirical features typically observed.

Suggested Citation

  • Eckhard Platen, 2005. "An Alternative Interest Rate Term Structure Model," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(06), pages 717-735.
    • Handle: RePEc:wsi:ijtafx:v:08:y:2005:i:06:n:s0219024905003244
    DOI: 10.1142/S0219024905003244
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    References listed on IDEAS

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    1. Jean-Philippe Bouchaud & Nicolas Sagna & Rama Cont & Nicole El-Karoui & Marc Potters, 1999. "Phenomenology of the interest rate curve," Applied Mathematical Finance, Taylor & Francis Journals, vol. 6(3), pages 209-232.
    2. W. Breymann & A. Dias & P. Embrechts, 2003. "Dependence structures for multivariate high-frequency data in finance," Quantitative Finance, Taylor & Francis Journals, vol. 3(1), pages 1-14.
    3. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305, World Scientific Publishing Co. Pte. Ltd..
    4. David Heath & Eckhard Platen, 2002. "Perfect Hedging Of Index Derivatives Under A Minimal Market Model," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 5(07), pages 757-774.
    5. Leif Andersen & Jesper Andreasen, 2000. "Volatility skews and extensions of the Libor market model," Applied Mathematical Finance, Taylor & Francis Journals, vol. 7(1), pages 1-32.
    6. Miltersen, Kristian R & Sandmann, Klaus & Sondermann, Dieter, 1997. "Closed Form Solutions for Term Structure Derivatives with Log-Normal Interest Rates," Journal of Finance, American Finance Association, vol. 52(1), pages 409-430, March.
    7. Platen, Eckhard, 2000. "A minimal financial market model," SFB 373 Discussion Papers 2000,91, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    8. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
    9. Long, John Jr., 1990. "The numeraire portfolio," Journal of Financial Economics, Elsevier, vol. 26(1), pages 29-69, July.
    10. Eckhard Platen, 2001. "Arbitrage in Continuous Complete Markets," Research Paper Series 72, Quantitative Finance Research Centre, University of Technology, Sydney.
    11. Andrew Matacz & Jean-Philippe Bouchaud, 2000. "An Empirical Investigation Of The Forward Interest Rate Term Structure," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 3(04), pages 703-729.
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    Cited by:

    1. Shane Miller, 2007. "Pricing of Contingent Claims Under the Real-World Measure," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 2-2007, January-A.
    2. Hardy Hulley & Shane Miller & Eckhard Platen, 2005. "Benchmarking and Fair Pricing Applied to Two Market Models," Research Paper Series 155, Quantitative Finance Research Centre, University of Technology, Sydney.
    3. Nicola Bruti-Liberati & Christina Nikitopoulos-Sklibosios & Eckhard Platen & Erik Schlögl, 2009. "Alternative Defaultable Term Structure Models," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 16(1), pages 1-31, March.
    4. Shane M. Miller & Eckhard Platen, 2008. "Analytic Pricing Of Contingent Claims Under The Real-World Measure," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(08), pages 841-867.
    5. El Qalli Yassine, 2009. "Term Structure Equations Under Benchmark Framework," EERI Research Paper Series EERI_RP_2009_13, Economics and Econometrics Research Institute (EERI), Brussels.
    6. Shane Miller & Eckhard Platen, 2004. "A Two-Factor Model for Low Interest Rate Regimes," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(1), pages 107-133, March.
    7. Hardy Hulley, 2009. "Strict Local Martingales in Continuous Financial Market Models," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 19, July-Dece.
    8. Hardy Hulley, 2009. "Strict Local Martingales in Continuous Financial Market Models," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 2-2009, January-A.
    9. Kevin John Fergusson, 2018. "Less-Expensive Pricing and Hedging of Extreme-Maturity Interest Rate Derivatives and Equity Index Options Under the Real-World Measure," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 3-2018, January-A.

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    More about this item

    Keywords

    Interest rate term structure; growth optimal portfolio; fair pricing; market price for risk; square root process;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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