Modeling the term structure of interest rates: A new approach

Abstract

The term structure of interest rates is modeled as a random field with conditional volatility. Random field models allow consistency with the current shape of the term structure without the need for recalibration. However, most such models are Gaussian, with no conditional volatility. State-dependent volatility is introduced while a key property of Gaussian random field models is retained. Each forward rate is part of a low-dimensional diffusion process, simplifying estimation and derivatives pricing. The modeling approach also implies that, in general, the set of zero coupon bonds does not complete the market, and term structure derivatives cannot always be priced by arbitrage.