Modeling Yield Curve Liquidity with an Elastic String

Summary

The document describes a model for fluctuations in the forward rate curve that treats it like a stiff elastic string. It connects shocks that move the curve to unexpected order flow, extending a price-only description into a microstructural account of prices and trading activity.

The framework is said to capture both market impact and cross-impact with fewer parameters than existing cross-impact models while providing comparable explanatory power. It also produces liquidity-dependent relationships between one tenor’s forward rate and order flow at another tenor, consistent with recent empirical findings. The authors further report that the model accounts for short-horizon departures from martingale price behavior. The supplied description does not give data details, parameter estimates, or tests beyond these comparisons, so it is not enough to assess the model’s predictive performance or practical use.

Key ideas

• The forward rate curve’s fluctuations are modeled as those of a stiff elastic string.
• Unexpected order flow acts as a source of shocks in the curve model.
• The framework incorporates price impact and cross-impact between tenors.
• Its reported explanatory power is comparable to existing cross-impact models with fewer parameters.
• The model links liquidity to cross-tenor rate and order-flow correlations and short-term non-martingale behavior.

Tags

# How does liquidity shape the yield curve?


# How does liquidity shape the yield curve?









The phenomenology of the forward rate curve (FRC) can be accurately understood by the fluctuations of a stiff elastic string (Le Coz and Bouchaud, 2024). By relating the exogenous shocks driving such fluctuations to the surprises in the order flows, we elevate the model from purely describing price variations to a microstructural model that incorporates the joint dynamics of prices and order flows, accounting for both impact and cross-impact effects. Remarkably, this framework allows for at least the same explanatory power as existing cross-impact models, while using significantly fewer parameters. In addition, our model generates liquidity-dependent correlations between the forward rate of one tenor and the order flow of another, consistent with recent empirical findings. We show that the model also account for the non-martingale behavior of prices at short timescales.

Shown in full with attribution under the source's licence. Licence: abstract CC0

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