Factor Models and the Shape of the Term Structure

26 Pages Posted: 1 Feb 1997

See all articles by Erik Schlögl

Erik Schlögl

University of Technology Sydney (UTS), Quantitative Finance Research Centre; University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management; Faculty of Science, Department of Statistics, University of Johannesburg; Financial Research Network (FIRN)

Daniel Sommer

University of Bonn

Multiple version iconThere are 2 versions of this paper

Date Written: January 1997

Abstract

The present paper analyses a broad range of one- and multifactor models of the term structure of interest rates. We assess the influence of the number of factors, mean reversion, and the factor probability distributions on the term structure shapes the models generate, and use spread options as an aggregate measure of the relative importance assigned to rising and falling forward rate curves by the models considered. We derive valuation formulas for these contingent claims in the multifactor Gaussian and CIR- models. Our main result is that the specification of mean reversion and the number of factors are both much more important for the relative movements of interest rates than the distributional characteristics of the factors. To the extent that interest rate risk depends on the movements of different parts of the term structure relative to one another rather than on shifts of its absolute level, the distributional assumption on the factor dynamics is found to be essentially irrelevant.

JEL Classification: G12, G13, E43

Suggested Citation

Schloegl, Erik and Sommer, Daniel, Factor Models and the Shape of the Term Structure (January 1997). Available at SSRN: https://ssrn.com/abstract=1145 or http://dx.doi.org/10.2139/ssrn.1145

Erik Schloegl (Contact Author)

University of Technology Sydney (UTS), Quantitative Finance Research Centre ( email )

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University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management ( email )

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Faculty of Science, Department of Statistics, University of Johannesburg ( email )

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Financial Research Network (FIRN)

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Queensland
Australia

HOME PAGE: http://www.firn.org.au

Daniel Sommer

University of Bonn ( email )

Postfach 2220
Bonn, D-53012
Germany
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+49 69 7447 1579 (Fax)

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