Log-Normal Interest Rate Models: Stability and Methodology
11 Pages Posted: 6 Mar 1997
Date Written: January 1997
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: Suggested Citation