Linear-Rational Term Structure Models

120 Pages Posted: 28 Feb 2014 Last revised: 20 Nov 2016

See all articles by Damir Filipović

Damir Filipović

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Martin Larsson

ETH Zurich - Department of Mathematics

Anders B. Trolle

HEC Paris - Finance Department

Date Written: March 3, 2016

Abstract

We introduce the class of linear-rational term structure models in which the state price density is modeled such that bond prices become linear-rational functions of the factors. This class is highly tractable with several distinct advantages: i) ensures nonnegative interest rates, ii) easily accommodates unspanned factors affecting volatility and risk premiums, and iii) admits semi-analytical solutions to swaptions. A parsimonious model specification within the linear-rational class has a very good fit to both interest rate swaps and swaptions since 1997 and captures many features of term structure, volatility, and risk premium dynamics — including when interest rates are close to the zero lower bound.

Keywords: Swaps, Swaptions, Unspanned Factors, Zero Lower Bound

JEL Classification: E43, G12, G13

Suggested Citation

Filipovic, Damir and Larsson, Martin and Trolle, Anders B., Linear-Rational Term Structure Models (March 3, 2016). Journal of Finance, Forthcoming; Swiss Finance Institute Research Paper No. 14-15. Available at SSRN: https://ssrn.com/abstract=2397898 or http://dx.doi.org/10.2139/ssrn.2397898

Damir Filipovic (Contact Author)

Ecole Polytechnique Fédérale de Lausanne ( email )

Odyssea
Station 5
Lausanne, 1015
Switzerland

HOME PAGE: http://people.epfl.ch/damir.filipovic

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Martin Larsson

ETH Zurich - Department of Mathematics ( email )

Ramistrasse 101
Zurich, 8092
Switzerland

HOME PAGE: http://math.ethz.ch/~larssonm

Anders B. Trolle

HEC Paris - Finance Department ( email )

France
+33 (0)1 39 67 98 70 (Phone)

HOME PAGE: http://sites.google.com/view/anderstrolle

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