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Can spanned term structure factors drive stochastic yield volatility?

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  • Christensen, Jens H.E.

    ()
    (Federal Reserve Bank of San Francisco)

  • Lopez, Jose A.

    ()
    (Federal Reserve Bank of San Francisco)

  • Rudebusch, Glenn D.

    ()
    (Federal Reserve Bank of San Francisco)

Abstract

The ability of the usual factors from empirical arbitrage-free representations of the term structure—that is, spanned factors—to account for interest rate volatility dynamics has been much debated. We examine this issue with a comprehensive set of new arbitrage-free term structure specifications that allow for spanned stochastic volatility to be linked to one or more of the yield curve factors. Using U.S. Treasury yields, we find that much realized stochastic volatility cannot be associated with spanned term structure factors. However, a simulation study reveals that the usual realized volatility metric is misleading when yields contain plausible measurement noise. We argue that other metrics should be used to validate stochastic volatility models.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2014-3.

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Length: 30 pages
Date of creation: Jan 2014
Date of revision:
Handle: RePEc:fip:fedfwp:2014-03

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Related research

Keywords: arbitrage-free Nelson-Siegel model; term structure modeling; interest rate risk; model validation;

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  1. Jens H.E. Christensen & Glenn D. Rudebusch, 2012. "The response of interest rates to U.S. and U.K. quantitative easing," Working Paper Series 2012-06, Federal Reserve Bank of San Francisco.
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  3. Jens H. E. Christensen & Jose A. Lopez & Glenn D. Rudebusch, 2010. "Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 143-178, 09.
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  7. Koopman, Siem Jan & Mallee, Max I. P. & Van der Wel, Michel, 2010. "Analyzing the Term Structure of Interest Rates Using the Dynamic Nelson–Siegel Model With Time-Varying Parameters," Journal of Business & Economic Statistics, American Statistical Association, vol. 28(3), pages 329-343.
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Cited by:
  1. Jens H.E. Christensen & Jose A. Lopez & Glenn D. Rudebusch, 2012. "Pricing deflation risk with U.S. Treasury yields," Working Paper Series 2012-07, Federal Reserve Bank of San Francisco.

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