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Journal Article

Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model

Francis A. Longstaff and Eduardo S. Schwartz
The Journal of Finance
Vol. 47, No. 4 (Sep., 1992), pp. 1259-1282
Published by: Wiley for the American Finance Association
DOI: 10.2307/2328939
Stable URL: http://www.jstor.org/stable/2328939
Page Count: 24
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Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model
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Abstract

We develop a two-factor general equilibrium model of the term structure. The factors are the short-term interest rate and the volatility of the short-term interest rate. We derive closed-form expressions for discount bonds and study the properties of the term structure implied by the model. The dependence of yields on volatility allows the model to capture many observed properties of the term structure. We also derive closed-form expressions for discount bond options. We use Hansen's generalized method of moments framework to test the cross-sectional restrictions imposed by the model. The tests support the two-factor model.

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