A filtered no arbitrage model for term structures from noisy data

We consider an affine term structure model of interest rates, where the factors satisfy a linear diffusion equation. We assume that the information available to an agent comes from observing the yields of a finite number of traded bonds and that this information is not sufficient to reconstruct exactly the factors. We derive a method to obtain arbitrage-free prices of illiquid or non traded bonds that are compatible with the available incomplete information. The method is based on an application of the Kalman filter for linear Gaussian systems. (C) 2004 Elsevier B.V. All rights reserved.