An Affine Model for International Bond Markets
45 Pages Posted: 4 Apr 2001
Date Written: May 2001
We present and estimate a parsimonious continuous-time multi-factor affine term structure model for the joint term structure dynamics of interest rates across countries. We extend the standard affine models by focusing on joint markets and by incorporating the exchange rate dynamics in the estimation procedure. Estimation is done by means of a Kalman filter algorithm and quasi maximum likelihood. We find that our particular three factor model is rather successful in fitting bond correlations, both within and between national bond markets. Moreover, the model sheds light on two of the most persistent puzzles in empirical international finance, i.e. the forward premium puzzle and the (bond portfolio) home bias puzzle. First, our model implies that deviations from uncovered interest rate parity are to be rationally expected in our model due to the existence of risk premia. Second and in line with Baillie and Bollerslev (2000), we find that the forward premium can be considered to be a statistical artefact due to the extremely slow convergence properties of the estimator towards the asymptotic distribution function. With respect to the home bias puzzle, the model allows to test for international diversification gains in unhedged bond return portfolios, conditional on information that is present in the joint term structure of both countries. We find that exchange rate risk is sufficiently priced such that the inclusion of foreign bonds allows for an improved risk-return trade-off from the perspective of a UK investor.
JEL Classification: C33, E43, G15
Suggested Citation: Suggested Citation