Arbitrage-Free Gaussian Affine Term Structure Model with Observable Factors

Abstract

This paper analyzes a simple discrete-time affine multifactor model of the term structure of interest rates in which the pricing factors that follow a Gaussian first-order vector autoregression are observable and there are no possibilities for risk-free arbitrage. We present the theoretical results for the compatible risk-neutral dynamics of observable factors in a maximally flexible way consistent with no-arbitrage under the assumption that the factor loadings of some yields are specified exogenously.