PRICE-ADMISSIBILITY CONDITIONS FOR ARBITRAGE-FREE LINEAR PRICE FUNCTION MODELS FOR THE TERM STRUCTURE OF INTEREST RATES

To assure price admissibility-that all bond prices, yields, and forward rates remain positive-we show how to control the state variables within the class of arbitrage-free linear price function models for the evolution of interest rate yield curves over time. Price admissibility is necessary to preclude cash-and-carry arbitrage, a market imperfection that can happen even with a risk-neutral diffusion process and positive bond prices. We assure price admissibility by (i) defining the state variables to be scaled partial sums of weighted coefficients of the exponential terms in the bond pricing function, (ii) identifying a simplex within which these state variables remain price admissible, and (iii) choosing a general functional form for the diffusion that selectively diminishes near the simplex boundary. By assuring that prices, yields, and forward rates remain positive with tractable diffusions for the physical and risk-neutral measures, an obstacle is removed from the wider acceptance of interest rate methods that are linear in prices.