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Rev Fin 2003; 16:679-716
© 2003 the Society for Financial Studies

Fundamental Properties of Bond Prices in Models of the Short-Term Rate

Antonio Mele
London School of Economics

Address correspondence to Antonio Mele, London School of Economics, Houghton Street, London WC2A 2AE, UK, or e-mail: a.mele{at}lse.ac.uk.

Abstract

This article develops restrictions that arbitrage-constrained bond prices impose on the short-term rate process in order to be consistent with given dynamic properties of the term structure of interest rates. The central focus is the relationship between bond prices and the short-term rate volatility. In both scalar and multidimensional diffusion settings, typical relationships between bond prices and volatility are generated by joint restrictions on the risk-neutralized drift functions of the state variables and convexity of bond prices with respect to the short-term rate. The theory is illustrated by several examples and is partially extended to accommodate the occurrence of jumps and default.


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