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J o l~ rn a l
o f F in a n c ia l
E c o n o m ic s
2 3 (1 9 8 9 ) 1 9 5 -2 2 4 .
N o rth -I-Io lla n d
F ra n c is A . L O N G S T A F F *
T h e O h ioS tu te
U rtio e rs i~ v ,
C o h .m h u .s ,
O H
4 3 .? 1 0 -1 3 0 9 ,
U S A
R e c e iv e d
J u n e
1 9 8 8 , tin a l
v e rs io n
re c e iv e d
F e b ru a ry
1 9 8 9
W e
d e riv e
a n d
te s t
a n
a lte rn a tiv e
c lo se d -fo rm
g e n e ra l
e q u ilib riu m
m odel
o f
th e
te r m
s tru c tu re :
w ith in
th e C o x , In g e rs o ll,
a n d
R o s s th e o re tic a l
fram ew o rk
m
w h ic h
y ie ld s
a r e n o n lin e a r
fim c tio n s
o f
th e
r is k - f r e e
ra te .
W e
s h o w
th a t
e q u ilib riu m
b o n d
p ric e s
a n d
th e
r is k - f r e e
r a te
a re
n o + a lw a y s
in v e rs e ly
re la te d
a n d
th a t
b o n d
r is k
n e e d
n o t
b e
s tr ic tly
in c re a s in g
in
m a tu rity .
U sing
H ansen\u2019s
g e n e ra liz e d
m e th o d
o f m o m e n ts
to o b ta in
param eter
e s tim a te s ,
th is
n o n lin e a r
m odel
o u tp e rfo rm s
th e
C ox,
In g e rso ll,
a n d
R oss
s q u a re
ro o t
m odel
in
d e s c rib in g
a c tu a l
T re a s u ry
b ill y ie id s
fo r
th e
1 9 6 4 -1 9 8 6
p e rio d .
M o d e lin g
the term
stru c tu re
of interest rates has alw ays been of fundam en-
ta l
im p o rta n c e
to
b o th
fin a n c ia l
e c o n o m is ts
a n d
p ra c titio n e rs .
I n
a
re c e n t
p a p e r,
C o x , In g e is o ll,
a n d
R o ss (C R )
(1985a) develop
a s im p le a n d
in tu itiv e
g e n e ra l
e q u ilib riu m
fram ew o rk
fo r
th e
p ric in g
of discount
b o n d s
(th e
te r m
s tru c tu re )
a n d
o th e r
c o n t!n g e n t
claim s
in
a
c o n tin u o u s -tim e
econom y.
A n
a d v a n ta g e
of the CIR
fra m b ? w o rk o v e r p a rtia l
e q u ilib riu m
a p p ro a c h e s \u201d
is that
the risk-free
rate and
its d y n a m ic s a re d e te rm in e d
e n d o g e n o u s ly
as part of the
g e n e ra l
e q u ilib riu m .
Thus, interest-rate
d y n a m ic s
th a t
p erm it
a rb itra g e
a re
p re c lu d e d ,
a p ro p e rty
th s t
c a n n o t
always be guaranteed
in a partial
e q u ilib -
riu m
s e ttin g .
I n
a
c o m p a n io n
p a p e r,
C
(1 9 8 5 b )
p ro v id e
a
s p e c ific
e x a m p le
o f
th e ir
fram ew o rk
b y d e riv in g
a clio
-fo rm
m o d e l o f th e te rm
stru c tu re
jn a sim ple
o n e -s ta te -v a ria b le
lin e a r p ro d u c tio n
e c o n o m y . A lth o u g h
in n o v a tiv e ,
th is m o d e l
[w h ich
w :
d e s ig n a te
the square
ro o t
( S
)
n -ro d e ]] d o e s
not capture
fu lly
th e
\u201cI am
g ra te fu l
fo r th e c o m m e n ts
re c e iv e d
fro m
W arren
IM cy.
S tc p h c n
Bukcr. M ~chacl
E d
K ane,
T o n y
S a n d e rs ,
R e r+ @S tu b ,
a n d
fin a n c e
w
k s h a p
p a rtic ip a n ts
a t th e
U n iv ersity
T he
O h io
S ta te
U n iv e rs ity ,
a n d
th e
U n iv ctsity
o f
a s h in g to n .
Ia m
p a rtic u la rly
g ra te fu l
fo r
? h c
s u g g e s tio n s
a n d
c o m m e n ts
of the referee, Eduardo
S :;h w a rtz ,
A ll errors
a rc
m v
re s p o n G b ilit> .
\u2019F o r
e x a q d c ,
see M erton
(1973), Vasicek
(1 9 7 7 ).
D ::th an
(1 9 X ).
R ic h a rd
(IW ).
h r~ n n a n
a n d
S c h w a rtz
(1 9 7 9 ).
k a n g e tie g
(1 9 8 0 ). O ld fie ld
a n d
R ogalski
(19X 7). and
H e a th .
Jarro w .
a n d
M o rto n
(l\u201d s8 7 ).
1 9 6
F.A .
L o r t g s t u f f ,A w n lin e u r
m odel of the term structure
o b s e rv e d
p ro p e rtie s
o f th e te rm
s tru c tu re .
F o r e x a m p le , it im p lie s th a t
te r m
p re m iu m s
a re
m o n o to n e
in c re a s in g fu n c tio n s
o f m a tu rity .
R e c e n t e v id e n c e
i n
th a t
a c tu a l
te r
c o m p lic a te d
p a tte rn s .
C le a rly , w e w o u ld lik e to b e a b le to a v o id th e s e lim ita tio
th e
a d v a n ta g e s
a n d
in tu itiv e
a p p e a l
o f th e C I
ro a c h
t o
m o d e lin g
the term
s tru c tu re .
One poss
u c e
a d d itio n a l
s ta te v a ria b le s in to th e a n a ly s is . U n fo rtu n a te ly ,
how ever,
p re a c h
i s
v e ry
tly
i n
term s
o f
tra c ta b ility
a n d
th e
num bers
o f
ttro n a l p a ra m e te rs
t
m u s t b e e s tim a te d .
p a p e r
in tro d u c e s
a sim pler and
m ore direct way
of addressing
th e s e
a llo w in g
te c h n o lo g ic a l
c h a n g e
t o
a ffe c t
p ro d u c tio n
re tu rn s
e d e riv e a n a lte rn a tiv e c lo s e d -fo rm
g e n e rA
e q u i!ib riu m
m odel of
re w ithin the C IR
(1 9 8 5 a j fra m e w o rk
in w h ic h d is c o u n t b o n d
n e a r
fu n c tio n s
o f th e
r is k - f r e e
in te re s t
ra te .
T h is
n o n h n e a r
d e p e n d e n c e
r e s u lts
in a richer set of yield
c u rv e
a n d
te r m
p re m iu m
s h a p e s
w ith o u t in tro d u c in g
a d d itio n a l s ta te v a ria b le s o r p a ra m e te rs .
F o r e x a m p le , th is
m odel
[d e s ig n a te d
th e
d o u b le
s q u a re
ro o t
(D S R )
m o d e l]
is c o n s is te n t
w ith
b c th
hum ps
a n d
tro u g h s
i n
th e
y ie ld
c u rv e
a s
w e ll a s
w ith
m o n o to n e
o r
p a tte rn s
of term
prem ium s.
1 new
a n d
su rp risin g fin d in g s e m e rg e fro m
th is n o n lin e a r
m o d e l. F o r
e x a m p le , w e s h o ? N th a t e q u ilib riu m
discount bond prices and
interest rates are
n o t
a lw a y s
in v e rs e ly
re la te d ;
th a t
d is c o u n t
b o n d
p ric e s
c a n
b e
in c re a s in g
fu n c tio n s
of the risk-free rate in som e situations. This property
h a s im p o rta n t
lic a tio n s
for t
in v e rtib ility
of bond
prices. In
a d d itio n ,
we show
th a t
rs c o u n t
b o n d
r i
n e s s
n e e d
n o t
b e
a
m o n o to n e
in c re a s in g
fu n c tio n
o f
m atu rity
o r d u ra tio n .
F in a lly , w e s h o w
th a t th e lo c a l e x p e c ta tio n s
h y p o th e s is
c a n h o ld s im u lta n e o u s ly
for som e bonds
a n d
not others.
m pirical
perform ance
o f
th e
S R
a n d
D SR
m o d e ls
i n
tructure, w e first use H ansen\u2019s (1982) generalized
m e th o d
) te c h n iq u e
t o
o b ta in
p o in t e s tim a te s
o f th e p a ra m e te rs
o f
then com pare
th e y ie ld s im p lie d
by each
m o d e l w ith
th e
actual yields on Treasury
b ills d u rin g
th e 1 9 6 4 -1 9 8 6 p e rio d
e show
th a t th e
e a n
s q u a re d
e rro r
th a n
th e
S R
m o d e l.
I n
el are m ore serially
c o rre la te d
a n d
m o re
y related
t o
th e
level of t> ie risk-free
ra te . F in a lly ,
w e test
th e
y ie ld
er changes
i n
th e
s q u a re
o n tro llin g
for changes
i n
ts strongly
s u p p o rt
th e h y p o th e s is
th a t
ree rat
F .A .
Lo rtg stu fl
A
u o rtlirre u r
m odel
o fth e te rm
s tru c tu re
d e s c rib in g
th e
a lte rn a tiv e
a s s u .
tio n ,
a n d
u n c o n d iti
sum m arizes
th e m a jo r re s u lts o f th e p a p e r a n d p re s e n ts
c o n c lu d in g
rem arks.
In th is s e c tio n , w e u s e th e g e n e ra l e q u ilib riu m
fram ew or
d e riv e
a n
e x p lic it
m odel of bond
p ric in g
a n d
th e
te r m
tu re
of interest
ra te s . T h is m o d e l c o m p le m e n ts
th e S K m o d e l d e riv e d
b y
(1 9 8 5 b j, w h ic h
is also
d e v e lo p e d
w ith in th e C IR
(1 9 8 5 a ) th e o re tic a l
fram ew ork.
a re ra tio n a l
e x p e c ta tio n
g e n e ra l e q u ilib riu m
m o d e ls in w h ic h th e in te re s tra te ,
in te r e s t- r a te
dynam ics, bond prices, and bond-price
d y n a m ic s
are endogenous.
T he
C IF L (1 9 8 5 a )
g e n e ra l e q u ilib riu m
fram ew o rk
c a n
b e
sum m arized
a s
fo llo w s.
T h e re
i s
a
fin ite
num ber
o f
c o n s ta n t
s to c h a s tic
re tu rn s
t o
s c a le
p ro d u c tio n
te c h n o lo g ie s
that produce
a s in g le g o o d
th a t
c a n
b e a llo c a te d
t o
e ith e r
consum prion
o r in v e s tm e n t.
T h e re
is a ls o a fix e d n u m b e r
o f id e n tic a l
in d iv id u a ls
w ho
m axim ize
a
tim e -a d d itiv e
e x p e c te d
u tility
of con
fu n c tio n
b y
s e le c tin g
o p tim a l c o n s u m p tio n
a n d
in v e s tm e n t
p o lic ie s .
p lic ity ,
a ll in ? J e s tm e n t is d o n e b y
f i
s and
th e in d iv id u a ls
in v e s ta ll o f th e i?
unconsum ed
w e a lth in th e s h a re s
o s e
firm s .
T h e
v d u e s
o f
th e
firm s
fo lh
a m u1tivariate
d iffu sio n
p ro c e s s .
a n d o m
te c h n o lo g ic a l
c h a n g e is in tro d u c e d
b y
tillo w in g
th e
d rift
v e c to r
a n d
c o v a ria n c e
m atrix
fo r
th is
m u ltiv a ria te
d iffu sio n
p ro c e s s to d e p e n d o n a v e c to r o f s ta te v a ria b le s
th a t is a ls o g o v e rn e d
b y
a m u h iv a ria te
d ifI\u2019u sio n p ro c e ss. T h e jo in t
p ro c e s s
for the fir
th e
s ta te
v a ria b le s
c o m p le te ly
d e s c rib e s
th e
s ta te
p e rfe c t
c o m p e titiv e
m a rk e ts fo r c o n tin u c u s
tra d in
v a rie ty
o f c o n tin g e n t
c la im s , a s w e ll a s fo r in s ta n
a n d
le n d in g .
E q u ilib riu m
i n
th is
e c o n o
ra te , p ric e c , fo r th e c o n tin g e n t c la im s , a n d
th e to t
tio n
p la n s .
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