Ab initio yield curve dynamics

Details Ab initio yield curve dynamics Ab initio yield curve dynamics

2005-07-13

arxiv.org/abs/physics/0507098v1

Physics

Data Analysis, Statistics and Probability

11 LateX pages, 2 figures

Scientific paper

We derive an equation of motion for interest-rate yield curves by applying a minimum Fisher information variational approach to the implied probability density. By construction, solutions to the equation of motion recover observed bond prices. More significantly, the form of the resulting equation explains the success of the Nelson Siegel approach to fitting static yield curves and the empirically observed modal structure of yield curves. A practical numerical implementation of this equation of motion is found by using the Karhunen-Loeve expansion and Galerkin's method to formulate a reduced-order model of yield curve dynamics.

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