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

TLDR

The model’s factors are the short‑term interest rate and its volatility. The study develops a two‑factor general equilibrium model of the term structure. The authors derive closed‑form expressions for discount bonds and bond options, analyze the resulting term‑structure properties, and employ Hansen’s GMM to test the model’s cross‑sectional restrictions. The model’s yield dependence on volatility captures many observed term‑structure features, and empirical tests using Hansen’s GMM support the two‑factor specification.

Abstract

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.