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Can interest rate volatility be extracted from the cross section of bond yields?

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  • Collin-Dufresne, Pierre
  • Goldstein, Robert S.
  • Jones, Christopher S.
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    Abstract

    Most affine models of the term structure with stochastic volatility predict that the variance of the short rate should play a 'dual role' in that it should also equal a linear combination of yields. However, we find that estimation of a standard affine three-factor model results in a variance state variable that, while instrumental in explaining the shape of the yield curve, is essentially unrelated to GARCH estimates of the quadratic variation of the spot rate process or to implied variances from options. We then investigate four-factor affine models. Of the models tested, only the model that exhibits 'unspanned stochastic volatility' (USV) generates both realistic short rate volatility estimates and a good cross-sectional fit. Our findings suggest that short rate volatility cannot be extracted from the cross-section of bond prices. In particular, short rate volatility and convexity are only weakly correlated.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 94 (2009)
    Issue (Month): 1 (October)
    Pages: 47-66

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    Handle: RePEc:eee:jfinec:v:94:y:2009:i:1:p:47-66

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Term structure of interest rates Affine models Stochastic volatility;

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    Cited by:
    1. Christensen, Jens H.E. & Lopez, Jose A. & Rudebusch, Glenn D., 2014. "Can spanned term structure factors drive stochastic yield volatility?," Working Paper Series 2014-3, Federal Reserve Bank of San Francisco.
    2. Jerry Tsai, 2013. "Rare Disasters and the Term Structure of Interest Rates," Economics Series Working Papers 665, University of Oxford, Department of Economics.
    3. Almeida, Caio & Graveline, Jeremy J. & Joslin, Scott, 2011. "Do interest rate options contain information about excess returns?," Journal of Econometrics, Elsevier, vol. 164(1), pages 35-44, September.
    4. Jens H.E. Christensen, 2013. "A regime-switching model of the yield curve at the zero bound," Working Paper Series 2013-34, Federal Reserve Bank of San Francisco.
    5. Christensen, Jens H.E. & Rudebusch, Glenn D., 2013. "Modeling yields at the zero lower bound: are shadow rates the solution?," Working Paper Series 2013-39, Federal Reserve Bank of San Francisco.
    6. Ruslan Bikbov & Mikhail Chernov, 2010. "No-arbitrage macroeconomic determinants of the yield curve," Post-Print hal-00732517, HAL.
    7. Márcio Laurini & João Frois Caldeira, 2012. "Some Comments on a Macro-Finance Model with Stochastic Volatility," IBMEC RJ Economics Discussion Papers 2012-04, Economics Research Group, IBMEC Business School - Rio de Janeiro.
    8. Kim, Don H. & Singleton, Kenneth J., 2012. "Term structure models and the zero bound: An empirical investigation of Japanese yields," Journal of Econometrics, Elsevier, vol. 170(1), pages 32-49.

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