Unspanned Stochastic Volatility in the Linear-Rational Square-Root Model: Evidence from the Treasury Market *

68 Pages Posted: 29 Jun 2020 Last revised: 5 Jun 2024

See all articles by Jorge Wolfgang Hansen

Jorge Wolfgang Hansen

Aarhus University - Department of Economics and Business Economics; Aarhus University; Danish Finance Institute (DFI)

Date Written: June 4, 2020

Abstract

We examine the linear-rational square-root (LRSQ) models' ability to capture crosssectional and time-series dynamics of bond yields and their variances simultaneously. The preferred model specification has five factors, two of which are not spanned by the yield curve, introducing unspanned stochastic volatility (USV). This specification provides a close in-sample fit to yields and yield variances, emphasizing the need of USV. Out-of-sample, it demonstrates low variance forecast errors. Additionally, the model provides evidence of USV in conditional yield variance and bond risk premia, which is linked to macroeconomic uncertainty.

Keywords: Interest rate model, Treasury market, Unscented Kalman filter, Unspanned stochastic volatility, Unspanned risk premia JEL Classification: C32, G12, E43

JEL Classification: C32, G12, E43

Suggested Citation

Hansen, Jorge Wolfgang, Unspanned Stochastic Volatility in the Linear-Rational Square-Root Model: Evidence from the Treasury Market * (June 4, 2020). Available at SSRN: https://ssrn.com/abstract=3618969 or http://dx.doi.org/10.2139/ssrn.3618969

Jorge Wolfgang Hansen (Contact Author)

Aarhus University - Department of Economics and Business Economics ( email )

Fuglesangs Allé 4
Aarhus V, 8210
Denmark

Aarhus University ( email )

Nordre Ringgade 1
DK-8000 Aarhus C, 8000
Denmark

Danish Finance Institute (DFI) ( email )

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