Term Structure Model

Abstract

In financial economics we model investors’ attitudes towards risk in order to come up with a reasonable relationship of risk and return in the relevant market. In standard microeconomic theory investors’ tastes are modeled by specifying their utility function, being, for example, an investor with a logarithmic utility function as in the production-exchange economy of Cox, Ingersoll, and Ross (1985a). To get a utility function for a representative investor, we then aggregate the utility functions across investors with potential aggregation problems.⁷⁵ In an equilibrium term structure model this utility function indirectly enters into the form of the market price of risk. However, looking at real world security markets we see different investors present on different trading days. Thus, we could model these changing representative tastes over time by allowing for a dynamic behavior of the market price of risk λ(t). This approach is inspired by a shift from modeling static tastes as with previous term structure models to capture the beliefs of the dynamic behavior of tastes. Instead of assuming the same representative investor being present over time, i.e. assuming λ (t) = const, we set up a plausible dynamic model of how the market price of risk possibly fluctuates over time.