The Term Structure of Interest Rates as a Random Field

The Charles A. Dice Center for Research in Financial Economics Working Paper No. 97-5

Posted: 21 Aug 1997

See all articles by Robert S. Goldstein

Robert S. Goldstein

University of Minnesota - Twin Cities - Carlson School of Management; National Bureau of Economic Research (NBER)

Date Written: June 12, 1997

Abstract

Note: This abstract was revised by the author December 1997.

Forward rate dynamics are modeled as a random field. In contrast to multi-factor models, random field models offer a parsimonious description of term structure dynamics, while eliminating the self-inconsistent practice of recalibration. The form of the drift of the instantaneous forward rate process necessary to preclude arbitrage under the risk neutral measure is obtained. Forward measures are characterized, and used to price a bond option when the forward volatility structure depends upon the square root of the current spot rate. In addition, it is demonstrated that random field models offer a parsimonious method to account for parameter uncertainty, inherently predicting that the best hedging instrument for a given asset is one of similar maturity. Finally, a random field is shown to be supported within a general equilibrium framework, allowing the risk-neutral measure and risk premia to be identified.

JEL Classification: E43, G12

Suggested Citation

Goldstein, Robert S., The Term Structure of Interest Rates as a Random Field (December 1997). The Charles A. Dice Center for Research in Financial Economics Working Paper No. 97-5, Available at SSRN: https://ssrn.com/abstract=197652

Robert S. Goldstein (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

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National Bureau of Economic Research (NBER)

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