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# Journal of Financial Economics 5 (1977) 177-188.

0 North-Holland

AN EQUILIBRIUM

CHARACTERIZATION
STRUCTURE

Publishing Company

OF THE TERM

Oldrich VASICEK*
Wells Fargo Bank and University of California, Berkeley, CA, U.S.A.
The paper derives a general form of the term structure of interest rates. The following assumptions are made: (A.l) The instantaneous (spot) interest rate follows a diffusion process;
(A.2) the price of a discount bond depends only on the spot rate over its term; and (A.3) the
market is efficient. Under these assumptions, it is shown by means of an arbitrage argument
that the expected rate of return on any bond in excess of the spot rate is proportional to its
standard deviation. This property is then used to derive a partial differential equation for
bond prices. The solution to that equation is given in the form of a stochastic integral representation. An interpretation of the bond pricing formula is provided. The model is illustrated on
a specific case.

1. Introduction

Although considerable attention has been paid to equilibrium conditions in
capital markets and the pricing of capital assets, few results are directly applicable to description of the interest rate structure. The most notable exceptions
are the works of Roll (1970, 1971), Merton (1973, 1974), and Long (1974). This
paper gives an explicit characterization of the term structure of interest rates in
an efficient market. The development of the model is based on an arbitrage
argument similar to that of Black and Scholes (1973) for option pricing. The
model is formulated in continuous time, although some implications for
discrete interest rate series are also noted.
2. Notation and assumptions
Consider a market in which investors buy and issue default free claims on a
specified sum of money to be delivered at a given future date. Such claims will
be called (discount) bonds. Let P(t, s) denote the price at time t of a discount
bond maturing at time s, t 5 s, with unit maturity value,
P(s,s) = 1.
*The author wishes to thank P. Boyle, M. Garman, M. Jensen, and the referees, R. Roll
E

The subsequent values of the spot rate. logP(t. (1) The rates R(t. this equation can be written as F(t. Define now the spot rate as the instantaneous borrowing and lending rate. the current value r(t) of the spot rate is the instantaneous rate of increase of the loan value. (5) This equation holds with certainty. however. The forward rate F(t. The Markov property implies that the spot rate process is characterized by a single state variable. T) = . (3) The forward rate can be interpreted as the marginal rate of return from committing a bond investment for an additional instant. (4) T-+0 A loan of amount W at the spot rate will thus increase in value by the increment d W = Wr(t)dt. 5”) considered as a function of T will be referred to as the term structure at time t. that is. The probability distribution of the segment {r(r). 0) = lim R(t. Second. [(s. are not necessarily certain. T) = -. At any time t.l) The spot rate follows a continuous Markov process. namely its current value.178 0. subject to two requirements: First. r)dr. Vasicek. T) is the internal rate of return at time t on a bond with maturity date s = t+T. it will be assumed that r(t) is a stochastic process.t)R(t. r(t) = R(t. T> 0. s-t)]. R(t. r(t) is a continuous function of time. the future development of the spot rate given its present value is independent of the past development that has led to the present level. The following assumption is thus made : (A. T). . it is assumed that r(t) follows a Markov process. s) = . In fact. t+ T). Equilibrium and term structure The yield to maturity R(t. z 2 t} is thus completely determined by the value of r(t). Under this assumption. s) will be defined by the equation s t+T R(t. F(t. it does not change value by an instantaneous jump. f (2) In the form explicit for the forward rate.

2). depends only on the current value r(t). No particular form of such relationship is presumed. since they all postulate that R(t. (6) where z(t) is a Wiener process with incremental variance dt.=r(r)dr)+n(t. it will be assumed that the following is true: (A. It may be noted that the expectation hypothesis. (7) Thus. and the liquidity preference hypothesis all conform to assumption (A.2) The price P(t. t)dz.3) The market is efficient. r(t)). that is. and every investor acts rationally (prefers more wealth to less. Gikhman and Skorokhod (1969)] by a stochastic differential equation of the form dr =f(r. 1) the development of the spot rate process over an interval (t. Vasicek. The second assumption will thus be stated as follows: (A. s). i 5 s. By assumption (A. s) of a discount bond is determined by the assessment. j.3) implies that investors have homogeneous expectations. t) are the instantaneous drift and variance. They can be described [cf. with various specifications for the function 5. the value of the spot rate is the only state variable for the whole term structure. P(t. given its values prior to time I. Expectations formed with the knowledge of the whole past develop- .2) then implies that the price P(t. Assumption (A. by the current assessment of the development of the spot rate over the term of the bond. Equilibrium and term structure 179 Processes that are Markov and continuous are called diffusion processes. or more accurately. t). Finally. the market segmentation hypothesis. s) = P(1. s. r(r)). respectively. It8 (1961). It is natural to expect that the price of a discount bond will be determined solely by the spot interest rate over its term. there are no transactions costs. at time t. information is available to all investors simultaneously. T) = E. and that no profitable riskless arbitrage is possible. p’(r. and uses all available information). Assumption (A. The functions f(r. T. of the process r(t). (. s) is a function of v(t). t)dt+p(r. of the segment {T(T).t 5 7 5 s} of the spot rate process over the term of the bond.0.

The total worth W = W.WI of the portfolio thus constructed changes over time according to the accumulation equation dW = (W~PL(~. . s) = o(t. cr(t. Since there exists only one state variable. and simultaneously buys an amount W. (8) ~(t. s.. r) are the mean and variance. are equivalent to expectations conditional only on the present value of the spot rate. This equation follows from eq. Suppose that the amounts WI. r). where the parameters s)dz. 9 m s. (7) by the It6 differentiation rule [cf. that the bond price satisfies a stochastic differential equation dP = Pp(t. 02(t. s.180 0.))dz (11) [cf. r) = - p&y P .dt. sl). s.r). respectively. s. WI = WC s2M4c 4 w2 %MC a- = J+w. Investors unwilling to revise the composition of their portfolio continuously will need a spectrum of maturities to fulfil their investment objectives.u(t. s. including the present term structure. . W. s) = . 4c s2)). This means that the short bond and just one other bond completely span the whole of the term structure. It8 (1961). (6). +I-- Wlo(t. S)dt-Pa@. given that the current spot rate is r(t) = r. Merton (1971)]. . the instantaneous returns on bonds of different maturities are perfectly correlated. s. are chosen to be proportional to a(t. of a bond maturing at time s2. however. r(t)). - 46 sz)). The functions ~(t. s2)- J+‘. ~~))d~--W’2~(t. The term structure equation It follows from eqs. respectively. Now consider an investor who at time t issues an amount WI of a bond with maturity date sl. of the instantaneous rate of return at time t on a bond with maturity date s.&strGm (1970)]. 3. Equilibrium and term structure ment of rates of all maturities. cr(t. (8) by application of the ItB rule.. It should be noted. for instance. s2). that bond returns over a finite period are not correlated perfectly. r(t)) are given by a(t. Vasicek. Kushner (1967).

the portfolio can be bought with funds borrowed at the spot rate. 4 (13) Since eq.3).l). If not.3). comparison of eqs.)& sz))(&. ~1)-cl@. Eq. s)-r(t))/a(t. after rearrangement. (5) and (12) yields MC s2b(f. It will be called the term structure equation. Writing (14) as P(C s.46 s2N= r(O. s.r &. (Tfrom eqs. (13) is valid for arbitrary maturity dates sl. (A. r) can be called the market price of risk.0. r>= At. or equivalently.2). since the stochastic element dz is not present in (12). r) specified. t % s. s. (15) is the basic equation for pricing of discount bonds in a market characterized by Assumptions (A. Equilibrium and term structure 181 Then the second term in eq. As such arbitrage opportunities are ruled out by Assumption (A. r) . as it specifies the increase in expected instantaneous rate of return on a bond per an additional unit of risk. it follows that the ratio (‘(t. or otherwise sold and the proceeds lent out. (9). (14) will now be used to derive an equation for the price of a discount bond. The term structure equation is a partial differential equation for P(t. ap a2p \$+(f+P4) +\$p2aT-rP z = 0. to accomplish a riskless arbitrage. G)-l dt. s. (10) yields. r)a(t. sl). given that the current spot rate is r(r) = r. and substituting for p. r> ’ s 2 t. r). (12) The portfolio composed of such amounts of the two bonds is instantaneously riskless. M(t. (A. (15) Eq. sl) .40 46 \$2) * df. (5). Once the character of the spot rate process r(t) is described and the market price of risk q(t.si> -AC sM& s2))lW. Vasicek. s2. Let q(t. and the equation takes the form d W = wOl(t. r). ~(6 4 -r(t) = cc(Cs2). s) is independent of s. s. r>. (14) The quantity q(t. It should therefore realize the same return as a loan at the spot rate described by eq. (11) disappears. r) denote the common value of such ratio for a bond of any maturity date. 3.r = s(t. the bond prices are obtained by solving (15) .00. 40.

s)V(u). Such representation for the bond price as a solution to the term structure equation (15) and its boundary condition is as follows : P(t.0. a+ ap ar2 du+Vs pdz+PV(-r-_3q2)du > ap V -ar pqdu a2p dr2-rP du+PVqdz+ > ap Va7pdz . s. define and apply Ito’s differential rule to the process P(u. r) = 1. r(r))ds(r) . Friedman (19731. Stochastic representation of the bond price Solutions of partial differential equations of the parabolic or elliptic type. can be represented in an integral form in terms of an underlying stochastic process [cf. R(t. r(f)). To prove (18).logP(t. Then d(W) = VdP+PdV+dPdV = V ap ap z+fz++ 2 +PVqdz++PVq2du+ = V g+Cf+pq)z+fp’ ( ap = PVqdz+Vspdz. T) of interest rates is then readily evaluated from the equation t+ T. such as eq.s) = ~*elp(-_S:r(r)di-tS:g’(r. (16) The term structure R(t.r(r))dr + ’ q(r. s t (18) t % s. T) = -. (15). Epilibrium and term structure 182 subject to the boundary condition P(s. Vasicek. (17) 4.

dt. a>. (15). co)dt = rdt-t+q2dt-qdz. Construct a portfolio consisting of the long bond (bond whose maturity approaches infinity) and lending or borrowing at the spot rate. m)dt--(T(t. Integrating from t to s and taking expectation yields and eq. This yields d(logQ) oo)dz+(l = A/. (18) can be given an interpretation in economic terms. Equilibrium and term structure by virtue of eq. e-r(o)l~2(t.exp(-j:r(r)dr). eq. co)dz)+(l -A)Qe. where nw = (At. t s s. co)dt-h(t. (this corresponds to q = 0). The price Q(t) of such portfolio follows the equation dQ = lQ(p(t. This equation can be integrated by evaluating the differential of 1ogQ and noting that A(t)a(t. r(t)). as) = q(t. -A)rdt-+A202(t.183 0. Eq. Vasicek. and consequently Thus. the bond price is given by P(t.s) = GQWlQ(s>. In the special case when the expected instantaneous rates of return on bonds of all maturities are the same. respectively. (20) This means that a bond of any maturity is priced in such a way that the same .s) = E. with proportions A(t). 1 -A(t). (18) follows.@. (18) can be written in the form PO.

Although the market price of risk can be estimated from the defining eq. WMt. if the present bond price is a certain fraction of the value of the portfolio Q. (23). and the market price of risk 4. Equilibrium and term structure portion of a certain well-defined combination of the long bond and the riskless asset (the portfolio Q) can be bought now for the amount of the bond price as is expected to be bought at the maturity date for the maturity value. (21) follows. p are known. 5. PO. the term structure of interest rates will now be obtained explicitly in the situation characterized by the following assump- . r2(t)-2 2 dT I TdJ’ (23) By comparison of (22). p of the spot rate process. (14). Eq.184 0. (20) states that the price of any bond measured in units of the value of such portfolio Q follows a martingale. as well as for applications of the results.s) = Q(t) E w.r(O)). Equivalently. (21) r=lJ Once the parametersf. r(t)). and putting s = t. The former two quantities can be obtained by statistical analysis of the (observable) process r(t).f(t. r(t))-pp(t. eq. it is necessary to know the parametersf. A specific case To illustrate the general model. r(t)) *s(t. In empirical testing of the model. s) tjzss. (22) s=t But from (1) a9 P = s=. it is desirable to have a more direct means of observing q empirically. then the future value of the bond is expected to stay the same fraction of the value of that portfolio. Vasicek. This yields a+ as2 = r’(t) -. QGi’ Thus. The following equality can be employed: aR aT = %fk r(t)) + dt. q could thus be determined from the slope at the origin of the yield curves. eq. (21) can be proven by taking the second derivative with respect to s of (18) (Ito’s differentiation rule is needed).

_e-. In contrast to the random walk (the Wiener process). Vasicek. (27) . The conditional expectation and variance of the process given the current level are l&r(s) = y + (r(t) . independent of the calendar time and of the level of the spot rate. t 6 s. The stochastic element. the Ornstein-Uhlenbeck process possesses a stationary distribution. which is an unstable process and after a long time will diverge to infinite values. (25) t 5 s. (26) respectively. fashion. Equilibrium and term structure 185 tions: First. Second. corresponding to the choicef(r. It is a Markov process with normally distributed increments. s. It is not claimed that the process given by eq.y)e-“I(s-‘l. the solution of the term structure equation (15) subject to (16) [or alternatively. p(t. with a > 0. r) = p in eq. that the market price of risk q(t. This description of the spot rate process has been proposed by Merton (1971). (6). r) is a constant. Under such assumptions. r) = cc(y-r). (24) represents the best description of the spot rate behavior. Var. causes the process to fluctuate around the level y in an erratic.0.r(s) = g (1 -e-*“(“-r)). The instantaneous drift a(y -r) represents a force that keeps pulling the process towards its long-term mean y with magnitude proportional to the deviation of the process from the mean. r) = exp k (1 -e-“(“-‘j)@(m)-r)-(s-t)R(oo) [ -g3 (1 . which has a constant instantaneous variance p*. the representation (18)] is P(t. that the spot rate r(t) follows the so-called Ornstein-Uhlenbeck process. this specification serves only as an example. The Ornstein-Uhlenbeck process with a > 0 is sometimes called the elastic random walk. dr = a(y-r)dt+pdz.(s-o)2 1 t 5 s. In the absence of empirical results on the character of the spot rate process. but continuous.

(lo). S) = !! (1 -e-a(s-r)). as T-P co. Note that the yield on a very long bond. s) = r(r)+! rate of (1 -e-“‘S-“). For values of r(t) larger than that . S) of the instantaneous return of a bond maturing at time s is. For values of r(t) smaller or equal to the yield curve is monotonically but below increasing. (9). It is seen that the longer the term of the bond. S) and standard deviation a(t. the higher the variance of the instantaneous rate of return. cr(t. Vasicek. a with r 5 S. For a very long bond (i. T) = R(co)+(r(t)-R(w)) +\$T(l-e-aT)2. is R(co). with the expected return in excess of the spot rate being proportional to the standard deviation. and approach a common asymptote R(w) as T --) co. s + co) the mean and standard deviation approach the limits . (28) The mean ~(1.e.. &(l -e-aT) T 2 0. p(t. Equilibriumand term structure 186 where R(a) = y+pq/u-\$p2/rx2.400) = rW+pq/a.0. from eqs. cr(co) = p/CL The term structure of interest rates is then calculated from eqs. It takes the form R(t. The yield curves given by (29) start at the current level r(r) of the spot rate for T = 0. thus explaining the notation (28). (17) and (22).

Tz 0. at a given time t. Using eqs.T). is lognormally distributed. s) given its current value P(t. (26). and R(t. T) given R(t. fully characterizes the behavior of interest rates under the specific assumptions of this section. together with the spot rate process (24).p.It is similar in form to the shape of the curves used by McCulloch (1975) in fitting observed . The relationship between the rates R(t._.) follows a first-order linear normal autoregressive process of the form R.are obtained from (29) by use of (25).. (25).. eq. (29) imply that the discrete rate series. which characterizes the degree to which the next term in the series {R. The calculations are elementary and will not be done here. In particular. The process (30) is the discrete elastic random walk. Since r(t) is normally distributed by virtue of the properties of the Ornstein-Uhlenbeck process.0. the liquidity premium implied by the term structure (29) is given by n(T)= F(t.). R(t. fluctuating around its mean c. = R(nT. T). q. among rates of different maturities. a more appropriate name would be the term premium]. When r(t) is equal to or exceeds this last value. Nelson (1972)].t < z.. Eq. (29). T) is a linear function of r(t). (29) written for T = T. it follows that R(t. t I s. The difference between the forward rates and expected spot rates. > The liquidity premium (31) is a smooth function of the term T. s). TJ of two arbitrary maturities can be determined by eliminating r(t) from eq.. Moreover. over time.T = T2. [cf.1. (30) with independent residuals E. (3) and (25).}is tied to the current value. The parameters c. (29) describes the development of the rate R(t. a.2 .. Equilibrium and term structure 187 it is a humped curve. considered as a function of the term is usually referred to as the liquidity premium [although. T) is also normally distributed. (l). = c+a(R. as well as bond prices. R. Vasicek. (24). Also. The mean and variance of R(z. It provides both the relationship. the constant a.r(t+T) R(a)-? ff \$ emrrT (1 -e-‘=). T)of a given maturity over time. as Nelson (1972) argues. CI. (26). n=0. T. The price P(T. and s2 = E&icould be expressed in terms of y. and (29).t+T)-E. the yield curves are monotonically decreasing.-c)+E. is given by a = eeaT. (29) can be used to ascertain the behavior of bond prices. and the behavior of interest rates. It will only be noted that eqs. with parameters of the distribution calculated using eqs.

Roll. K. F. 1970. New York).. R. If q 2 p/u. 1975. 131-170. 1. Stock prices. New York).H. 1974. It&. 1973. Stochastic differential equations and applications (Academic Press..K. The pricing of options and corporate liabilities. n(T) is a monotonically increasing function of T. Its values for T = 0 and T = 03 are n(0) = 0. 1973.188 0. Skorokhod. inflation.. 1967. 867-887. Kushner. Journal of Political Economy 81. Vasicek.. Stochastic stability and control (Academic Press. 1974. Gikhman. Scholes. Nelson. J. Journal of Finance 29. New York). Black. Merton. Journal of Economic Theory 3. log . Bombay). 1971. Lectures on stochastic processes (Tata Institute. 1971. Journal of Political Economy 83.C. . Econometrica 41. 51-66. Merton.. On the pricing of corporate debt: The risk structure of interest rates. R.R. The term structure of interest rates (Basic Books.V. 637-654. For 0 c q -c p/a. Saunders. Philadelphia.B.J. Introduction to the theory of random processes (W. Journal of Finance 26..1. decreasing References AstrGm. and M. H. the latter being the difference between the yield on the very long bond and the long-term mean of the spot rate.C.pla . 1970. Optimum consumption and portfolio rules in a continuous-time model. PA). respectively. then z(T) is a monotonically function.. Friedman. Journal of Financial Economics 1..C. with maximum of q2/2 occurring at T = .. An intertemporal capital asset pricing model. Merton. Long. and A. J. Introduction to stochastic control theory (Academic Press.B. and the term structure of interest rates. New York). ( p/a-q > If the market price of risk q 6 0. New York). R. it has a humped shape. An estimate of the liquidity premium. R. The behavior of interest rates: The application of the efficient market model to U.J. 1961. A. 1975. C.. Equilibrium and term structure estimates of liquidity premia.S. Roll. Investment diversification and bond maturity.. 1969.373-413.449470. 1972. McCulloch.. I = R(co)--y. R. 95-119. treasury bills (Basic Books.