No. 519: Modelling the Yield Curve: A Two Components Approach
John Hatgioannides City University Menelaos Karanasos University of York Marika Karanassou Queen Mary, University of London
September 1, 2004
Abstract
Using parametric return autocorrelation tests and non parametric variance ratio statistics show that the UK and US short-term interest rates are unit root processes with significant mean reverting components. Congruent with this empirical evidence, we develop a new continuous time term structure model which assumes that the dynamics of the instantaneous interest rate are given by the joint effect of a (stationary) mean reverting component and a (nonstationary) martingale component. We provide a closed-form solution for the equilibrium yield curve when the temporary component is modelled as an Ornstein-Uhlenbeck process and the permanent component is modelled as an Arithmetic Brownian motion process.
J.E.L classification codes: C20, E43, G12
Keywords: C20, E43, G12