Forthcoming publication in JF for Profs. Filipovic and Trolle

The current environment with very low interest rates creates difficulties for many existing models of the term structure of interest rates (prevailing interest rates as function of their term). This paper introduces a new class of "linear-rational" term structure models. These models have several advantages over the industry-standard affine models. First, they produce rates that are bounded from below, an important feature in the current market environment. Second, they allow for factors that drive volatility and bond risk premiums without affecting bond prices themselves, which are key characteristics of bond markets. Third, they admit analytical solutions to so-called swaptions – an important class of interest rate derivatives that underlie the valuation of mortgage-backed securities, callable agency securities, life insurance products, and a wide variety of structured products. The linear-rational models have many potential industry applications in the contexts of trading, pricing, hedging, and risk-managing bonds and interest rate derivatives.