Term structure of interest rates and implied market frictions

Abstract

The assumption of frictionless markets, often made in order to simplify a finance problem, is very familiar to researchers in finance and economics. Modeling the shape of aggregate friction in the market is not an easy task and has not been extensively dealt with in the literature. In this paper we present a methodology that allows us to impute a friction function implied by the market data together with a term structure estimate. The methodology utilizes the dual relation that exists between the function and the minimization criterion used to estimate the term structure of interest rates. A theoretical model, which imposes only moderate economically motivated assumptions on the shape of the friction function, is developed and implemented numerically. The market data reveals that market friction is not symmetric, while it is usually (but perhaps unintentionally) assumed in the term structure estimation that they are. Consequently, classical techniques of estimating the structure may yield a 'deformed' shape of the term structure.