INSIGHTS: A New Taxonomy of the Dynamic Term Structure Models

Sanjay K. Nawalkha, Natalia A. Beliaeve and Gloria Soto

Volume 8, Number 4, Fourth Quarter 2010

This paper gives a new taxonomy of dynamic termstructure models (TSMs) that classifies all existing TSMs as either fundamental models or preference-free single-plus, double-plus, and triple-plus models.We exemplify the new taxonomy by considering preference-free versions of some well-known fundamental short rate models. Single-plus extensions of the fundamental models are shown to be both time-homogeneous and preference-free-two characteristics which do not simultaneously hold under any existing class of TSMs. Though the analytical apparatus for pricing fixed income securities is identical under fundamental models and single-plus models, the latter models are consistent with general non-linear forms of MPRs which may also depend upon an arbitrary set of state variables, leading to better estimates of risk-neutral parameters. The preference-free doubleplus and triple-plus extensions of the fundamental models are similar to the Heath et al. (1992) models, in that time-inhomogeneous drifts and volatilities are used as “smoothing variables” to fit the initial bond prices and initial term structure of volatilities, respectively.