Longstaff and Schwartz: A Two-Factor Equilibrium Model

Longstaff and Schwartz (LS) [38] developed a two-factor model of the term structure based on the framework of Cox, Ingersoll and Ross [18] discussed in Chapter 2. The two factors are the short-term interest rate and the instantaneous variance of changes in this rate (volatility of the short-term interest rate). Therefore the prices of contingent claims reflect the current levels of the interest rate and its volatility. The choice of interest rate volatility as the second state variable is supported by the fact that volatility is a key variable in contingent claim pricing.