Yield Curve Dynamics

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M.Sc. ProposalYield Curve Dynamics

Phillipus Cornelius BlomUniversity of the Witwatersrand

Contents

1 Introduction 32 Information Geometry for Yield Curves 5

2.1 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52.2 Characterisation of the bond process . . . . . . . . . . . . . . 52.3 Distance Between Functions . . . . . . . . . . . . . . . . . . . 72.4 Hilbert space characteristics . . . . . . . . . . . . . . . . . . . 9

3 Objectives 10

3.1 Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103.2 Practical Application . . . . . . . . . . . . . . . . . . . . . . . 10

1 INTRODUCTION

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1 Introduction

Each and every day future cash-flows are priced by many financial institu-tions. In order to calculate the value of a future cash-flow, in today’s terms,it is necessary to introduce time value of money. Interest rates provide themechanism by which to do this. Discounting the future cash-flow by therequired interest rate and time period, one can determine the value of thiscash-flow today. Implicit in this statement is the fact that future cash-flowsoccur at different times. Conceivably then, different time periods as wellas different interest rates should be used to discount future cash-flows of differing maturity. This leads, naturally, to the idea of a yield (or interestrate) curve. A yield curve describes the relationship between time to ma-turity and interest rates. From a yield curve it is possible to determine theappropriate interest rate to be used given a certain time to maturity.These institutions will firstly be interested in what this yield curve lookslike today. After determining this, they might want to know what the yieldcurve will look like tomorrow or the next day. Alternatively, the questionmight be stated: What is the relationship between the yield curve todayand some time in the future.The evolution (or dynamics) of the yield curve has been an area of in-terest for several decades. Since the seminal paper by Black and Scholes[6],interest rate models have developed at a rapid pace.There are two types of interest rate models. The first type of interestrate model is termed an equilibrium model. The model first makes cer-tain assumptions based on the observed or theoretical economy. From theseassumptions a process is generated that models interest rates. The pro-cess therefore reflects the behaviour of interest rates under the guise of aneconomic model. Fitting the initial term structure of interest rates to anequilibrium model is however difficult. The fit is usually only an approxi-mation and a significant amount of error may be introduced. The secondtype of model is termed an no-arbitrage model. Unlike equilibrium models,no-arbitrage models are designed to fit the initial term structure exactly. Inshort, with equilibrium models the initial term structure is an output of themodel; with no-arbitrage models the initial term structure is an input.Let us consider the usual properties of a good interest rate model:

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The possible ranges of the interest rates should be reasonable. Thatis, we will not commonly allow interest rates to become negative norallow them to diverge is some unpredictable fashion

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Interest rates seem to tend to a long-term mean. Unlike stock prices,interest rates do not grow at some rate but rather revert to their mean.

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Although negative interest rates have been observed before, it shall be assumed thatsuch circumstances are anomalous. It implies that 1 unit of currency is worth moretomorrow than today.

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