The Stochastic Behavior of Interest Rates : Implications from a Nonlinear , Continuous-Time , Multifactor Model

This paper presents a general, nonlinear version of existing multifactor models, such as Longstaff and Schwartz (1992). The novel aspect of our approach is that rather than choosing the model parameterization out of “thin air”, our processes are generated from the data using approximation methods for multifactor continuous-time Markov processes. In applying this technique to the shortand long-end of the term structure for a general two-factor diffusion process for interest rates, a major finding is that the volatility of interest rates is increasing in the level of interest rates only for sharply, upward sloping term structures. In fact, the slope of the term structure plays a larger role in determining the magnitude of the diffusion coefficient. As an application, we analyze the model’s implications for term structure pricing, focusing on the conditional distribution of interest rates and the term structure of term premiums and volatilities.

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