Purebred or Hybrid: Reproducing the Volatility in Term Structure Dynamics

Posted: 26 Nov 2001

See all articles by Dong-Hyun Ahn

Dong-Hyun Ahn

University of North Carolina at Chapel Hill

Robert F. Dittmar

University of Michigan, Stephen M. Ross School of Business

A. Ronald Gallant

Duke University - Fuqua School of Business, Economics Group; New York University - Department of Economics

Bin Gao

University of North Carolina (UNC) at Chapel Hill - Finance Area

Abstract

This paper investigates the implications of mixtures of affine, quadratic, and nonlinear models for the term structure of volatility. The dynamics of the term structure of interest rates appear to exhibit pronounced time-varying or stochastic volatility. Ahn, Dittmar, and Gallant (2000) provide evidence suggesting that term structure models incorporating a set of quadratic state variables are better able to reproduce yield dynamics than affine models, though none of the models is able to fully capture the term structure of volatility. In this study, we combine affine, quadratic and nonlinear factors in order to maximize the strengths of a term structure model in generating heteroskedastic volatility. We show that this combination entails a tradeoff between specification of heteroskedastic volatility and correlations among the state variables. By combining these factors, we are able to gauge the cost of this tradeoff. Using the Efficient Method of Moments [Gallant and Tauchen (1996)], we find that augmenting a quadratic model with a nonlinear factor results in improvement in fit over a model characterized only by quadratic factors. Since the nonlinear factor is characterized by stronger dependence of volatility on the level of the factor, we conclude that flexibility in the specification of both level dependence and correlation structure are important for describing term structure dynamics.

Keywords: Asset Pricing - Theoretical, Asset Pricing - Empirical, Term Structure of Interest Rates - Empirical, Term Structure of Interest Rates - Theoretical

JEL Classification: G0, G1, C5

Suggested Citation

Ahn, Dong-Hyun and Dittmar, Robert F. and Gallant, A. Ronald and Gao, Bin, Purebred or Hybrid: Reproducing the Volatility in Term Structure Dynamics. Journal of Econometrics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=286161

Dong-Hyun Ahn

University of North Carolina at Chapel Hill ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-3203 (Phone)
919-962-2068 (Fax)

Robert F. Dittmar

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

A. Ronald Gallant (Contact Author)

Duke University - Fuqua School of Business, Economics Group ( email )

Box 90097
Durham, NC 27708-0097
United States

New York University - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States

Bin Gao

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-0054 (Fax)

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