Term Structure of Interest Rates and Implied Market Frictions: The Min-Max Approach

It is often assumed that financial markets are frictionless. Bond markets are illiquid and bond prices are observed with errors. The magnitude of these errors leads to violation of no-arbitrage conditions and, consequently, prevents researchers from obtaining an estimate of the term structure (TS) of interest rates. Researchers have had to settle for a second-best estimate of the TS (e.g., obtained via regression) at a cost of an economically unrealistic assumption of symmetric market frictions. The true shape of market frictions, however, is not known and generally is a highly complex issue. A no-arbitrage-based methodology that avoids making detrimental assumptions is developed here. It facilitates empirical investigation of the shape of the market frictions and of the TS that are simultaneously imputed from market data assuming “efficient” market frictions that minimize the maximum net arbitrage. The empirical investigation performed in the Canadian and U.S. markets shows that in both markets the frictions are asymmetric and the estimates of the TS produced via regression and our methodology significantly differ.