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Rev Fin 1999; 12:721-762
© 1999 the Society for Financial Studies

Article

A parametric nonlinear model of term structure dynamics

DH Ahn and B Gao
University of North Carolina, USA
Correspondence to: DH Ahn, Finance Department, Kenan-Flagler Business School, University of North Carolina, CB 3490, McColl Building, Chapel Hill, NC 27599-3490, USA

Abstract

Recent nonparametric estimation studies pioneered by Ait-Sahalia document that the diffusion of the short rate is similar to the parametric function, r1.5, estimated by Chan et al., whereas the drift is substantially nonlinear in the short rate. These empirical properties call into question the efficacy of the existing affine term structure models and beg for alternative models which admit the observed behavior. This article presents such a model. Our model delivers closed-form solutions for bond prices and a concave relationship between the interest rate and the yields. We show that in empirical analyses, our model outperforms the one-factor affine models in both time-series as well as cross-sectional tests.


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