A New Taxonomy of the Dynamic Term Structure Models

Abstract

This paper gives a new taxonomy of dynamic term structure models that classifies all existing TSMs as either fundamental models or preference-free singleplus, double-plus, and triple-plus models. We exemplify the new taxonomy by considering preference-free versions of some well-known fundamental short rate models. Single-plus extensions of the fundamental models are shown to be both timehomogeneous and preference-free - two characteristics which do not simultaneously hold under any existing class of TSMs. Though the analytical apparatus for pricing fixed income securities is identical under fundamental models and single-plus models, the latter models are consistent with general non-linear forms of MPRs which may also depend upon an arbitrary set of state variables, leading to better estimates of riskneutral parameters. The preference-free double-plus and triple-plus extensions of the fundamental models are similar to the Heath, Jarrow, and Morton [1992] models, in that time-inhomogeneous drifts and volatilities are used as “smoothing variables” to fit the initial bond prices and initial term structure of volatilities, respectively.