BFS 2002

Contributed Talk

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

Ioulia Ioffe, Eliezer Prisman

It is often assumed that financial markets are frictionless. This assumption serves well in some instances. However, in bond markets this assumption prevents researchers from obtaining an estimate of the term structure of interest rates (TS). This is because bond markets are illiquid and bond prices are observed with errors. These errors are so hefty 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 assumption 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 TS that are simultaneously imputed from market data. Our methodology is based on no-arbitrage arguments and an assumption that in "efficient" markets frictions will minimizing maximum net arbitrage. The empirical investigation is performed in the Canadian and the US markets. 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 US Treasury market is much more liquid than the Canadian bond market.