Arbitrage-free interest rate models and bond valuation methods connect through a newly derived framework that ties term premia and bond convexity directly to a continuous rebalancing trading strategy.
Whereas bond market participants must identify attractive valuations, arbitrage-free models rely on existing bond prices as their foundational inputs. As detailed in a 73-page working paper authored on November 6, 2026, and highlighted by papers.ssrn.com on November 13, 2026, bridging this gap demands rigorous definitions of bond convexity and term premium that stem from an active trading strategy rather than mere assumption.
The expected profit of continuously rebalancing a bond position funded at the short rate defines the term premium. Through the mechanical process of this derivation, the overall bond yield breaks down precisely into the lifetime convexity value, the term premium, and an expectation-hypothesis yield.
To evaluate this decomposition, the framework connects risk-neutral and physical measures through a single market-motivated condition. Absent news, benchmark yields stay where they are, creating a sliding curve condition that fixes the market price of rate risk without relying on unobservable parameters.
Specializing to a multi-factor quasi-Gaussian model with local and stochastic volatility reveals further complexities. Because volatility smiles and skews substantially alter convexity value even when models are calibrated to identical at-the-money volatilities, relying solely on at-the-money volatility to build a convexity correction proves inadequate.
| Model Component | Traditional Approach | Sliding Curve Framework |
|---|---|---|
| Term Premium | Postulated parameters | Derived from rebalancing strategy |
| Convexity Correction | At-the-money volatility alone | Local and stochastic volatility skew |
| Risk Price | Unobservable estimates | Fixed by absent-news benchmark condition |
The research also demonstrates that a known empirical estimate of term premia from swaps and swaptions matches this decomposition written in forward rates. The classification details of the work fall under JEL codes C63, E43, G12, and G13, addressing core intersections of computational modeling, interest rates, asset pricing, and contingent claims.
Disclaimer: The information provided in this article is for educational and informational purposes only and does not constitute financial advice.
