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A Two-Factor Model of the Term Structure: An Approximate Analytical Solution

Published online by Cambridge University Press:  06 April 2009

Stephen M. Schaefer  and
Eduardo S. Schwartz
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Abstract

This paper develops an approximate analytical solution to a two state-variable model of the term structure similar to the one proposed by Brennan and Schwartz. Unlike the BS model, which was based on the consol rate and the short rate of interest, our model is based on the consol rate and the spread (i.e., the difference) between the consol rate and the short rate. This change, merely a redefinition of variables, is made to exploit an assumption, for which there is substantial empirical evidence, that these two variables (the consol rate and the spread) are orthogonal. Employing orthogonal state variables provides the key simplification in providing an approximate solution to the fundamental valuation equation.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 19 , Issue 4 , December 1984 , pp. 413 - 424
Copyright
Copyright © School of Business Administration, University of Washington 1984

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