The Behavior of Interest Rates Implied by the Term Structure of Eurodollar Futures

This paper considers an equilibrium model of the term structure that is determined by two stochastic factors: a short-term interest rate and a target level to which the short rate is expected to revert. A Kalman filter technique that uses a time series, cross-section of Eurodollar futures prices is developed to estimate the parameters of the model. The term structures of spot LIBOR and Eurodollar futures volatility are compared to that predicted by the model. The empirical results indicate that the two-factor specification represents a significant improvement over its one-factor version.