University of Washington - Grant I. Butterbaugh Professor of Finance and Management
The arbitrage-free term structure models introduced here represent bond prices - not yields or forward rates - as a finite linear combination of fixed functions of the time to maturity. These models are structurally simpler than affine models, and the differential equation admits a general closed-form solution. Compatible specification of conditional stochastic volatility and correlation for the state variables is very general because the drift is not affected by the diffusion. A specific model within this family closely matches the widely-used Nelson-Siegel yield curves, demonstrating that practical, parsimonious models are available within this larger class of new models.