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Review of Finance Advance Access published online on December 25, 2008
Review of Finance, doi:10.1093/rof/rfn030
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© The Authors 2008. Published by Oxford University Press on behalf of the European Finance Association. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

A Convergence Model of the Term Structure of Interest Rates*

Viktors Ajevskis and Kristine Vitola

Bank of Latvia

This paper develops a convergence model of the term structure of interest rates in context of entering the European Monetary Union (EMU). Compared to other models developed so far in this field, our model specification ensures convergence of the domestic short-term interest rates to the euro area ones. We achieve this convergence by stating that the spread between domestic and euro short-term interest rate follows the Brownian bridge process. We also develop an econometric counterpart of the theoretical model. To tackle the problem of nonstationarity and nonlinearity of the model, we apply the extended Kalman filter for coefficient estimation.

Key Words: E43 • F36 • G12 • G15

* We are very grateful to an anonymous referee and the editor Bernard Dumas for helpful comments and suggestions. We kindly appreciate Jesper Lund for providing data. The views expressed herein are those of the authors and do not necessarily correspond to those of the Bank of Latvia.


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