Structural Models of Interest Rate Determination and Portfolio Behavior in the Corporate and Government Bond Markets

This paper summarizes some recent work in which we have modeled long-term interest rate determination in an explicit demand-supply context, using multi-equation structural models and directly contrasts such models with unrestricted reduced-form models. Wholly apart from questions of disaggregation and institutional detail, the explicitly structural nature of demand-supply models necessitates additional theoretical constructs beyond those required by unrestricted reduced-form models. Some of these conceptual inputs are already available from established portfolio theory, and others represent objects of current or prospective research. Experience to date with structural models of long-term interest rate determination suggests, however, that the exploitation of the richer theoretical framework yields not only insights about portfolio behavior but, very likely, improved interest rate models as well.