A two-factor model of the term structure with optimal filtering behaviour

F. Fornari & A. Mele
The rates of return of financial variables observed at high frequency are not normally distributed, mainly because of positive excess kurtosis; thus, most of the models developed in financial economics need be modified to take into account such characteristics of the data. On this respect GARCH models provide an appropriate modelling framework. Building on the convergence of an AR(1)-GARCH(1,1) model to a bivariate Ito process, we present a two-factor model for the term structure of...