The Central Tendency: A Second Factor in Bond Yields

Abstract

We assume the short-term rate to revert towards a central tendency which in, turn, is stochastically changing over time. We impose minimal restrictions on the joint behavior of the short-term rate and the central-tendency factor, and derive implications for the term structure of interest rates. The analysis suggests a proxy for the central tendency which is then used to estimate the short-term rate process. Our model captures variations in the short-term rate better than the Vasicek (1977) and Cox, Ingersoll and Ross (1985) models, where the central tendency is assumed to be constant. Also, the central-tendency proxy explains the conditional volatility of the short-term rate better than the short-term rate itself.

Keywords: term structure