Identifying Term Structure Volatility from the Libor-Swap Curve

Posted: 26 Jun 2008

Multiple version iconThere are 2 versions of this paper

Date Written: April 2008

Abstract

This paper proposes a new family of specification tests and applies them to affine term structure models of the London Interbank Offered Rate (LIBOR)-swap curve. Contrary to Dai and Singleton (), the tests show that when standard estimation techniques are used, affine models do a poor job of forecasting volatility at the short end of the term structure. Improving the volatility forecast does not require different models; rather, it requires a different estimation technique. The paper distinguishes between two econometric procedures for identifying volatility. The “cross-sectional” approach backs out volatility from a cross section of bond yields, and the “time-series” approach imputes volatility from time-series variation in yields. For an affine model, the volatility implied by the time-series procedure passes the specification tests, while the cross-sectionally identified volatility does not. This is surprising, since under correct specification, the “cross-sectional” approach is maximum likelihood. One explanation is that affine models are slightly misspecified; another is that bond yields do not span volatility, as in Collin-Dufresne and Goldstein ().

Keywords: C52, G13

Suggested Citation

Thompson, Samuel Brodsky, Identifying Term Structure Volatility from the Libor-Swap Curve (April 2008). Review of Financial Studies, Vol. 21, Issue 2, pp. 819-854, 2008. Available at SSRN: https://ssrn.com/abstract=1151598 or http://dx.doi.org/hhm082

Samuel Brodsky Thompson (Contact Author)

Arrowstreet Capital, L.P. ( email )

44 Brattle St., 5th Floor
Cambridge, MA 02138
United States
617 349 2254 (Phone)

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