An Affine Model for International Bond Markets

45 Pages Posted: 4 Apr 2001

See all articles by Hans Dewachter

Hans Dewachter

Catholic University of Leuven (KUL) - Department of Economics; Erasmus Research Institute of Management (ERIM)

Stan Maes

European Commission - DG Internal market and financial services; European Commission - DG Competition; KU Leuven - Department of Economics

Date Written: May 2001

Abstract

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

Dewachter, Hans and Maes, Konstantijn, An Affine Model for International Bond Markets (May 2001). Available at SSRN: https://ssrn.com/abstract=265750 or http://dx.doi.org/10.2139/ssrn.265750

Hans Dewachter (Contact Author)

Catholic University of Leuven (KUL) - Department of Economics ( email )

Center for Economic Studies
Naamsestraat 69
Leuven, B-3000
Belgium
+0032 16 326859 (Phone)
+0032 16 326796 (Fax)

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Konstantijn Maes

European Commission - DG Internal market and financial services ( email )

Rue de la Loi 200
Brussels, B-1049
Belgium

European Commission - DG Competition ( email )

Place Madou, Madouplein 1
Saint-Josse-ten-Noode/Sint-Joost-ten-Noode
Brussels, B-1049
Belgium

KU Leuven - Department of Economics ( email )

Naamsestraat 69
2nd Floor
B-3000 Leuven
Belgium

HOME PAGE: http://www.econ.kuleuven.ac.be/ew/academic/intecon

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
606
Abstract Views
2,261
rank
47,930
PlumX Metrics