A Macro Finance Term Structure Model with Stochastic Volatility

Abstract:     
This paper proposes a term structure model with macro VAR in a stochastic volatility setting. The specific feature of this model is that the risk premium of yields is directly driven by the time-varying variance-covariance of the VAR innovations, which is modeled by a Wishart Autoregressive process. Extending the essentially affine term structure model, this framework not only incorporates the stochastic variance-covariance in the VAR innovations, but also preserves the tractability and interpretability from a macro-finance perspective. Hence it provides a modeling tool to bridge the two strands of macroeconomic research: the DSGE-VAR with stochastic volatility and the macro-finance model of term structure. The baseline model implies that: 1) the stochastic variance-covariance of the VAR innovations has sizable effect on medium to long maturity yields; 2) volatility is a curvature factor of the yield curve, and the net effect of the time-varying variance-covariance matrix is also a curvature factor; 3) simulation study shows that it can well explain the bond yield "conundrum", where differences in volatility can result in different shapes of the yield curve with the underlying macro variables remaining at the same level.

Number of Pages in PDF File: 43

Keywords: Term structure, Stochastic volatility, Wishart Autoregressive process

JEL Classification: G12, E43

working papers series