Risk Premia and Volatilities in a Nonlinear Term Structure Model
London Business School
London Business School - Department of Finance
Philipp K. Illeditsch
University of Pennsylvania - Finance Department
March 24, 2015
We introduce a reduced form term structure model with closed form solutions for yields where the short rate and market prices of risk are nonlinear functions of Gaussian state variables. The nonlinear model with three Gaussian factors matches both the time-variation in expected excess returns and yield volatilities of U.S. Treasury bonds from 1961 to 2014. Yields depend on all three factors, yet the model exhibits features consistent with unspanned risk premia (URP) and unspanned stochastic volatility (USV). The probability of a high volatility scenario increases with the monetary experiment and remains high during the Greenspan area, even though volatilities came back down to normal levels.
Number of Pages in PDF File: 60
Keywords: Nonlinear term structure models, affine term structure models, expected excess returns, predictability, stochastic volatility, Unspanned Risk Premia (URP), Unspanned Stochastic Volatility (USV), hidden factors.
JEL Classification: D51, E43, E52, G12
Date posted: April 1, 2013 ; Last revised: March 26, 2015
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