The Central Tendency: A Second Factor in Bond Yields

Abstract

We assume that the instantaneous riskless rate reverts towards a central tendency which, in turn, is changing stochastically over time, and we derive a model of the term structure of interest rates. Our term-structure model implies that a linear combination of any two rates can be used as a proxy of the central tendency. Based on the central-tendency proxy, we estimate a model of the one-month rate which performs better than models which assume the central tendency to be constant.