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Tractable Term Structure Models and the Zero Lower Bound

48 Pages Posted: 22 Nov 2015 Last revised: 1 Dec 2015

Bruno Feunou

Bank of Canada

Jean-Sebastien Fontaine

Bank of Canada

Anh Le

University of North Carolina Kenan-Flagler Business School

Christian T. Lundblad

University of North Carolina Kenan-Flagler Business School

Date Written: October 1, 2015

Abstract

We greatly expand the space of tractable term structure models (TTSM). We consider one example of TTSM with positive yields together with rich volatility and correlations dynamics. Bond prices can be expressed in closed-form and estimation is straightforward. We find that the early stages of a recession have distinct effects on yield volatility. Upon entering a recession when yields are far from the lower bound, (1) the volatility term structure becomes flatter, (2) the level and slope of yields are nearly uncorrelated, and (3) the second principle component of yields plays a larger role. However, these facts are significantly different when yields are close to the lower bound. Entering a recession in such a setting, (1) the volatility term structure instead steepens, (2) the level and slope factors are strongly correlated, and (3) the second principle component of yields plays a smaller role. Existing DTSMs do not capture the changes in the cyclical responses of the volatility term structure near the lower bound.

Keywords: Term Structure, Zero Lower Bound, Stochastic Dominance, No-arbitrage

JEL Classification: G12

Suggested Citation

Feunou, Bruno and Fontaine, Jean-Sebastien and Le, Anh and Lundblad, Christian T., Tractable Term Structure Models and the Zero Lower Bound (October 1, 2015). Available at SSRN: https://ssrn.com/abstract=2693568 or http://dx.doi.org/10.2139/ssrn.2693568

Bruno Feunou

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-8302 (Phone)

HOME PAGE: http://kamkui.net/

Jean-Sebastien Fontaine (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

HOME PAGE: http://www.jean-sebastienfontaine.com

Anh Le

University of North Carolina Kenan-Flagler Business School ( email )

McColl Building
Chapel Hill, NC 27599-3490
United States

Christian Lundblad

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-8441 (Phone)

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