Log-Normal Interest Rate Models: Stability and Methodology

11 Pages Posted: 6 Mar 1997

See all articles by Klaus Sandmann

Klaus Sandmann

University of Bonn - The Bonn Graduate School of Economics

Dieter Sondermann

University of Bonn - Institute of Statistics

Multiple version iconThere are 2 versions of this paper

Date Written: January 1997

Abstract

The lognormal distribution assumption for the term structure of interest is the most natural way to exclude negative spot and forward rates. However, imposing this assumption on the continuously compounded interest rate has a serious drawback: rates explode and expected rollover returns are infinite even if the rollover period is arbitrarily short. As a consequence such models cannot price one of the most widely used hedging instrument on the Euromoney market, namely the Eurodollar future contract. The purpose of this paper is twofold: First to show that the problems with lognormal models result from modelling the wrong rate, namely the continuously compounded rate. If instead one models the effective annual rate these problems disappear. Second to give a survey on recent work on lognormal term structure models for effective or nominal forward rates.

JEL Classification: G13, E43

Suggested Citation

Sandmann, Klaus and Sondermann, Dieter, Log-Normal Interest Rate Models: Stability and Methodology (January 1997). Available at SSRN: https://ssrn.com/abstract=911 or http://dx.doi.org/10.2139/ssrn.911

Klaus Sandmann (Contact Author)

University of Bonn - The Bonn Graduate School of Economics ( email )

Adenauerallee 24-26
Bonn, D-53113
Germany

Dieter Sondermann

University of Bonn - Institute of Statistics ( email )

Adenauerallee 24-26
53113 Bonn, 53113
Germany

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