A Yield-factor Model of Interest Rates We Are Grateful for Discussions With

This paper presents a consistent and arbitrage free multi factor model of the term structure of interest rates in which yields at selected xed maturities follow a para metric multi variate Markov di usion process with stochastic volatility The yield of any zero coupon bond is taken to be a maturity dependent a ne combination of the selected basis set of yields We provide necessary and su cient conditions on the stochastic model for this a ne representation We include numerical techniques for solving the model as well as numerical techniques for calculating the prices of term structure derivative prices The case of jump di usions is also considered Please address all correspondence to Darrell Du e Graduate School of Business Stanford University Stanford CA We are grateful for discussions with Ken Singleton Bob Litterman Antoine Conze Nicole El Karoui Vincent Lacoste Jeremy Ev nine Antoine Frachot Henri Pag es Jean Philippe Lesne Fischer Black Ayman Hindy George Pennachi Rob Bliss Prasad Nannisetty Stan Pliska and Chris Rogers and espe cially to a referee for pointing out an error corrected in this version

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