Abstract

http://ssrn.com/abstract=2242280
 
 

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Risk Premia, Volatilities, and Sharpe Ratios in a Non-Linear Term Structure Model


Peter Feldhütter


London Business School

Christian Heyerdahl-Larsen


London Business School - Department of Finance

Philipp K. Illeditsch


University of Pennsylvania - Finance Department

December 17, 2013


Abstract:     
In this paper we propose an expansion of Gaussian term structure models where the short rate and market prices of risk are non-linear in the state variables. We provide closed-form solutions for bond prices and since the latent factors are Gaussian the expanded model is as tractable as the Gaussian model. We estimate a three-factor expanded model and find that the model matches the time variation in both expected excess returns and yield volatilities of U.S. Treasury bonds. Comparing Sharpe ratios in the Gaussian and expanded model, the expanded model implies that Treasury bonds are more attractive investments in periods with low volatility. A significant part of expected excess returns in the expanded model is not spanned by the cross section of yields. This suggests that more information than previously thought is contained in the yield curve, but in a non-linear way.

Number of Pages in PDF File: 50

Keywords: Affine term structure models, non-linear term structure models, time-varying term premiums, time-varying investment opportunities, stochastic volatility, Sharpe ratios, hidden factors

JEL Classification: D51, E43, E52, G12

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Date posted: April 1, 2013 ; Last revised: December 18, 2013

Suggested Citation

Feldhütter, Peter and Heyerdahl-Larsen, Christian and Illeditsch, Philipp K., Risk Premia, Volatilities, and Sharpe Ratios in a Non-Linear Term Structure Model (December 17, 2013). Available at SSRN: http://ssrn.com/abstract=2242280 or http://dx.doi.org/10.2139/ssrn.2242280

Contact Information

Peter Feldhütter
London Business School ( email )
Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
Christian Heyerdahl-Larsen
London Business School - Department of Finance ( email )
Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
Philipp K. Illeditsch (Contact Author)
University of Pennsylvania - Finance Department ( email )
The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-3477 (Phone)

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