Factor Models and the Shape of the Term Structure

Abstract

This article analyzes a broad range of one* and multifactor models of the term structure of interest rates. We assess the influence of the choice of 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. 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: E43, G12