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Risk Premia and Volatilities in a Nonlinear Term Structure Model

Review of Finance, Forthcoming

74 Pages Posted: 1 Apr 2013 Last revised: 10 Sep 2016

Peter Feldhütter

Copenhagen Business School; London Business School

Christian Heyerdahl-Larsen

London Business School - Department of Finance

Philipp K. Illeditsch

Tepper School of Business; University of Pennsylvania - Finance Department

Date Written: September 1, 2016

Abstract

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 factors matches the time-variation in expected excess returns and yield volatilities of U.S. Treasury bonds from 1961 to 2014. Yields and their variances depend on only three factors, yet the model exhibits features consistent with unspanned risk premia (URP) and unspanned stochastic volatility (USV).

Keywords: Nonlinear Term Structure Models, Expected Excess Returns, Stochastic Volatility, Unspanned Risk Premia (URP), Unspanned Stochastic Volatility (USV)

JEL Classification: D51, E43, E52, G12

Suggested Citation

Feldhütter, Peter and Heyerdahl-Larsen, Christian and Illeditsch, Philipp K., Risk Premia and Volatilities in a Nonlinear Term Structure Model (September 1, 2016). Review of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2242280 or http://dx.doi.org/10.2139/ssrn.2242280

Peter Feldhütter

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

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)

Tepper School of Business ( email )

Carnegie Mellon University
5000 Forbes Avenue
Pittsburgh, PA 15213
United States

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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