Can Linear-Rational Term Structure Models Capture Conditional Volatility in the Treasury Yield Market?

71 Pages Posted: 29 Jun 2020

See all articles by Jorge Hansen

Jorge Hansen

Aarhus University; CREATES; DFI

Date Written: June 4, 2020

Abstract

We show that the class of linear-rational square-root (LRSQ) model is able to match the cross section of yields and the time variability of conditional yield volatility simultaneously. Models in this class are, in this regard, able to break the tension noted for the affine term structure models from matching the conditional first and second moments of yields. Using a panel data set of US Treasury yields and realized yield volatilities, we evaluate the performance of various LRSQ model specifications based on in-sample and out-of-sample exercises and find that the preferred specification relies on three unspanned stochastic volatility factors, which, correlate strongly with
the level and slope factor of conditional yield volatility.

Keywords: Interest rate model, Treasury market, Unscented Kalman Filter, Unspanned stochastic volatility

JEL Classification: C32, G12

Suggested Citation

Hansen, Jorge, Can Linear-Rational Term Structure Models Capture Conditional Volatility in the Treasury Yield Market? (June 4, 2020). Available at SSRN: https://ssrn.com/abstract=3618969 or http://dx.doi.org/10.2139/ssrn.3618969

Jorge Hansen (Contact Author)

Aarhus University ( email )

Nordre Ringgade 1
DK-8000 Aarhus C, 8000
Denmark

CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

DFI ( email )

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