Abstract
We introduce the class of linear-rational term structure models, where the state price density is modeled such that bond prices become linear-rational functions of the factors. This class is highly tractable with several distinct advantages: i) ensures nonnegative interest rates, ii) easily accommodates unspanned factors affecting volatility and risk premiums, and iii) admits semi-analytical solutions to swaptions. A parsimonious model specification within the linear-rational class has a very good fit to both interest rate swaps and swaptions since 1997 and captures many features of term structure, volatility, and risk premium dynamics — including when interest rates are close to the zero lower bound.
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