Explaining the Forward Interest Rate Term Structure

Details Explaining the Forward Interest Rate Term Structure Explaining the Forward Interest Rate Term Structure

1999-09-28

arxiv.org/abs/cond-mat/9909396v1

Physics

Condensed Matter

12 pages, Latex + 4 EPS figures

Scientific paper

We present compelling empirical evidence for a new interpretation of the Forward Rate Curve (FRC) term structure. We find that the average FRC follows a square-root law, with a prefactor related to the spot volatility, suggesting a Value-at-Risk like pricing. We find a striking correlation between the instantaneous FRC and the past spot trend over a certain time horizon. This confirms the idea of an anticipated trend mechanism proposed earlier and provides a natural explanation for the observed shape of the FRC volatility. We find that the one-factor Gaussian Heath-Jarrow-Morton model calibrated to the empirical volatility function fails to adequately describe these features.

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