Abstract:
This paper proposes an alternative approach to the modeling of the interest rate term
structure. It suggests that the total market price for risk is an important factor that has
to be modeled carefully. The growth optimal portfolio, which is characterized by this
factor, is used as reference unit or benchmark for obtaining a consistent price system.
Benchmarked derivative prices are taken as conditional expectations of future benchmarked
prices under the real world probability measure. The inverse of the squared total
market price for risk is modeled as a square root process and shown to influence the
medium and long term forward rates, With constant parameters and constant short rate
the model already generates a hump shaped mean for the forward rate curve and other
empirical features typically observed.
