A Model of Discontinuous Interest Rate Behavior, Yield Curves, and Volatility

OLIN-97-21

Posted: 26 May 1998

See all articles by Steven L. Heston

Steven L. Heston

University of Maryland - Department of Finance

Date Written: December 1995

Abstract

This paper develops an equilibrium model in which interest rates follow a discontinuous (generalized) gamma process. The gamma process has finite variation, takes an infinite number of "small" jumps in every interval, and includes the Wiener process as a limiting case. The gamma interest rate model produces yield curves that closely resemble those of diffusion models. But in contrast to diffusion models, the curvature of the yield curve does not directly depend on the true volatility of the interest rate process, but instead depends on a different risk-neutral volatility. The gamma model appears to fit the distribution of interest rates changes and the jump characteristics of interest rate paths. Empirical tests reject a diffusion model of interest rates in favor of the more general gamma model because daily interest rate innovations are highly leptokurtic.

JEL Classification: E43, G12

Suggested Citation

Heston, Steven L., A Model of Discontinuous Interest Rate Behavior, Yield Curves, and Volatility (December 1995). OLIN-97-21, Available at SSRN: https://ssrn.com/abstract=86308

Steven L. Heston (Contact Author)

University of Maryland - Department of Finance ( email )

Robert H. Smith School of Business
Van Munching Hall
College Park, MD 20742
United States

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