An alternative interest rate term structure model

World Scientific Publishing Co.
Publication Type:
Journal Article
International Journal of Theoretical & Applied Finance, 2005, 8 (6), pp. 717 - 735
Issue Date:
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This paper proposes and alternative approach to the modeling of the interest rate twem 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 characterised by thie factor is used as reference unit or benchmark for obtaining a cosistent price system. Benchmarked derivative prices are tajen as conditional expectations of future bench-marked 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.
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