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ABSTRACT

The authors investigate the term structure of interest rates when the underlying state variables and production technologies follow the jump-diffusion processes. Even in some cases where the traditional expectations theory about the term structure is consistent with general equilibrium under diffusion processes, the traditional theory is not consistent under jump-diffusion processes. It is shown that bond prices are strictly higher under jump risks than otherwise and that consumers with logarithmic utility functions will develop hedge portfolios in the presence of jump diffusion.