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Testing Affine Term Structure Models in Case of Transaction Costs

34 Pages Posted: 31 Jan 2000  

Joost Driessen

Tilburg University - Center and Faculty of Economics and Business Administration; Tilburg University - Center for Economic Research (CentER)

Theo Nijman

Tilburg University - Center and Faculty of Economics and Business Administration

Bertrand Melenberg

Tilburg University - Center for Economic Research (CentER)

Date Written: September 15, 1999

Abstract

In this paper we empirically analyze the impact of transaction costs on the performance of affine interest rate models. We test the implied (no arbitrage) Euler restrictions, and we calculate the specification error bound of Hansen and Jagannathan to measure the extent to which a model is misspecified. Using data on T-bill and bond returns we find, under the assumption of frictionless markets, strong evidence of misspecification of one- and two-factor affine interest rate models. This is in line with earlier research. However, we show that the pricing errors of these models are reduced considerably, if relatively small transaction costs are taken into account. The average transaction costs for T-bills, due to the bid-ask spread, are around 1.5 basis points. At this size of transaction costs and for monthly holding periods, the misspecification of one- and two-factor affine interest rate models becomes statistically insignificant and economically very small. For quarterly holding periods, higher transaction costs of around 3 basis points are required to avoid misspecification.

JEL Classification: G21, E43

Suggested Citation

Driessen, Joost and Nijman, Theo and Melenberg, Bertrand, Testing Affine Term Structure Models in Case of Transaction Costs (September 15, 1999). Available at SSRN: https://ssrn.com/abstract=200088 or http://dx.doi.org/10.2139/ssrn.200088

Joost Driessen (Contact Author)

Tilburg University - Center and Faculty of Economics and Business Administration ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Theo Nijman

Tilburg University - Center and Faculty of Economics and Business Administration ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2342 (Phone)
+31 13 466 3280 (Fax)

Bertrand Melenberg

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2730 (Phone)

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