College of Business, The Ohio State University, and The Anderson Graduate School of Management, UCLA, respectively. We are grateful for the suggestions and comments of Avi Bick, Fischer Black, Riccardo Cesari, K. C. Chan, Michael Hemler, Andrew Karolyi, Chester Spatt; workshop participants at the University of British Columbia, the University of Colorado at Boulder, Columbia University, the University of Geneva, Harvard University, the University of Iowa, the Kansallis Foundation for Financial Research, New York University, the University of St. Gallen, UCLA, Washington University; and participants at the Research Institute of the Finnish Economy, the 1991 European Finance Association meetings, the Second Summer Symposium of the European Science Foundation Network in Financial Markets, the Second International Conference of the Centre for Research in Finance—IMI Group, the 1991 Western Finance Association meetings, and the 1991 Western Economic Association meetings. The first author acknowledges financial support from the Charles A. Dice Center for Research in Banking and Financial Economics. We are particularly grateful for the comments of two anonymous referees and the editor, René Stulz. All errors are our responsibility.
Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model
Article first published online: 30 APR 2012
1992 The American Finance Association
The Journal of Finance
Volume 47, Issue 4, pages 1259–1282, September 1992
How to Cite
LONGSTAFF, F. A. and SCHWARTZ, E. S. (1992), Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model. The Journal of Finance, 47: 1259–1282. doi: 10.1111/j.1540-6261.1992.tb04657.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
We develop a two-factor general equilibrium model of the term structure. The factors are the short-term interest rate and the volatility of the short-term interest rate. We derive closed-form expressions for discount bonds and study the properties of the term structure implied by the model. The dependence of yields on volatility allows the model to capture many observed properties of the term structure. We also derive closed-form expressions for discount bond options. We use Hansen's generalized method of moments framework to test the cross-sectional restrictions imposed by the model. The tests support the two-factor model.