Linear-Rational Term Structure Models

We introduce the class of linear-rational term structure models in which the state price density is modeled such that bond prices become linear-rational functions of the factors. This class is highly tractable with several distinct advantages: (i) ensures non-negative interest rates, (ii) easily accommodates unspanned factors affecting volatility and risk premiums, and (iii) admits semi-analytical solutions to swaptions. A parsimonious model specification within the linear-rational class has a very good fit to both interest rate swaps and swaptions since 1997 and captures many features of term structure, volatility, and risk premium dynamics-including when interest rates are close to the zero lower bound.