Demand and Supply Factors in the Term Structure of Interest Rates

Abstract

This paper corrects the no arbitrage condition in Vasicek (1977) by pointing out that the instantaneous spot rate is logically zero. The corrected no arbitrage condition admits an extremely simple solution, which allows the latent state factors to be accurately identified from the observable yields and unambiguously interpreted as the demand and supply factors. This solution can be interpreted as a continuous time version of the preferred habitat hypothesis of Modigliani and Sutch (1966), because the demand and supply factors are equivalent, by a uniform scale, to the preferred habitats of randomly arrived lenders and borrowers.