Quadratic Term Structure Models for Risk-Free and Defaultable Rates

Abstract. In this paper, quadratic term structure models (QTSMs) are ana-lyzed and characterized in a general Markovian setting. The primary motiva-tion for this work is to nd a useful extension of the traditional QTSM, which is based on an Ornstein{Uhlenbeck (OU) state process, while maintaining the analytical tractability of the model. To accomplish this, we introduce the class of quadratic processes, consisting of those Markov state processes which yield QTSMs. The main result states that OU processes are the only conservative quadratic processes. In general, however, a quadratic potential can be added to allow QTSMs to model default risk. It is further shown that the exponent functions that are inherent in the denition of the quadratic property can be determined by a system of Riccati equations with a unique admissible param-eter set. The implications of these results for modeling the term structure of risk-free and defaultable rates are discussed. 1.