Modelling the dynamics of the term structure of interest rates

Abstract

In order to provide tractable bond pricing formulae, the arbitrage theories of the term structure make specific assumptions as to the number, identity and process generating the underlying forcing variables. This paper assesses the empirical plausibility of these common assumptions. It is found that there are three underlying factors, one more than is usually permitted. However, by careful examination of the dynamics of suitable instrumental variables to these factors, it is found that the further factor may be represented by the autoregressive conditional volatility of one of these factors. Thus, it can be readily integrated into existing two factor models.