Interest Rate Volatility and the Term Structure: A Two‐Factor General Equilibrium Model

  • Author(s): FRANCIS A. LONGSTAFF, EDUARDO S. SCHWARTZ
  • Published: Apr 30, 2012
  • Pages: 1259-1282
  • DOI: 10.1111/j.1540-6261.1992.tb04657.x

ABSTRACT

We develop a two‐factor general equilibrium model of the term structure. The factors are the short‐term interest rate and the volatility of the short‐term interest rate. We derive closed‐form expressions for discount bonds and study the properties of the term structure implied by the model. The dependence of yields on volatility allows the model to capture many observed properties of the term structure. We also derive closed‐form expressions for discount bond options. We use Hansen's generalized method of moments framework to test the cross‐sectional restrictions imposed by the model. The tests support the two‐factor model.

Jump to menu

Main Navigation

Search the Site / Journal

Search Keywords

Search Tips

Members' Login

Credentials

Members' Options

Site Footer

View Mobile Version