Ioulia Ioffe, Principal Investigator

Term Structure of Interest Rates and Implied Market Friction: The MinMax Approach

It is often assumed that financial markets are frictionless. While serving well in some instances, in bond markets this assumption prevents researchers from obtaining an estimate of the term structure (TS) of interest rates. This is because bond markets are illiquid and bond prices are observed with errors. These errors are so large that they lead to violation of no-arbitrage conditions in the market. Researchers have had to settle for a second-best estimate of the TS (obtained via regression) at a cost of economically unrealistic assumptions of symmetric market frictions. The true shape of market frictions, however, is not known and generally is a highly complex issue. The methodology developed here avoids making detrimental assumptions. It facilitates empirical investigation of the shape of the market frictions and of the TSs that are simultaneously imputed from market data.

This methodology is based on no-arbitrage arguments and an assumption that in “efficient” markets, frictions will minimize maximum net arbitrage. The empirical investigation is performed in the Canadian and U.S. markets and involves implementation of non-linear optimization procedures. Preliminary results indicate that in both markets it is found that market frictions are not symmetric and the estimates of the TS produced via regression and the methodology developed here differ significantly. This difference is more pronounced in the Canadian market, which corresponds to the fact that the U.S. Treasury market is much more liquid than its Canadian counterpart.