A Gaussian Process of Yield Rates Calibrated with Strips

Abstract

This paper presents a Gaussian multivariate factor model of the term structure of interest rates. It shows that there exists a martingale valuation law of the factors so that the price function of a zero-coupon bond is an exponential spline. The model’s linear and Gaussian structure yields a simple model where estimation and calibration are relatively easy to do. Using yield data on stripped bonds, the spline model gives a very good approximation of the yield curve at all times. Moreover, the crucial Gaussian assumption is reasonable when modeling the dynamics for short periods like one year.