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An Admissible Affine Model for Joint Term Structure Dynamics of Interest Rates

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Author Info

  • Hans Dewachter

    ()
    (K.U.Leuven and Erasmus University Rotterdam)

  • Konstantijn Maes

    ()
    (K.U.Leuven, C.E.S., International Economics)

Abstract

We present and estimate a parsimonious continuous-time multi-factor affine term structure model for the joint term structure dynamics of interest rates across countries. We extend the standard affine models by focusing on joint markets and by incorporating the exchange rate dynamics in the estimation procedure. Estimation on UK-US term structure data is done by means of a Kalman filter algorithm and quasi maximum likelihood inference. We find that our particular three factor model is rather successful in fitting bond correlations, both within and between national bond markets. Moreover, the model sheds light on two of the most persistent puzzles in empirical international finance, i.e. the forward premium puzzle and the (bond portfolio) home bias puzzle. Our model implies that the empirical forward premium puzzle is due to (i) the existence of time varying risk premia and (ii) the small sample properties of the estimator caused by the strong inertia in (some of) the factors (in line with Baillie and Bollerslev (2000)). With respect to the home bias puzzle, the model allows to test for international diversification gains in unhedged bond return portfolios, conditional on information that is present in the joint term structure of both countries. We find that exchange rate risk is sufficiently priced such that the inclusion of foreign bonds allows for an improved time-dependent risk-return trade off from the perspective of a UK investor.

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Bibliographic Info

Paper provided by Katholieke Universiteit Leuven, Centrum voor Economische Studiën, International Economics in its series International Economics Working Papers Series with number wpie001.

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Length: 46 pages
Date of creation: Feb 2001
Date of revision:
Handle: RePEc:kul:kulwps:wpie001

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Related research

Keywords: forward premium anomaly; affine joint term structure model; kalman filter;

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Cited by:
  1. Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2011. "Properties of Foreign Exchange Risk Premiums," CEPR Discussion Papers 8503, C.E.P.R. Discussion Papers.
  2. Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2010. "Properties of Foreign Exchange Risk Premia," MPRA Paper 21302, University Library of Munich, Germany.
  3. Antonio Diez De Los Rios, 2009. "Can Affine Term Structure Models Help Us Predict Exchange Rates?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(4), pages 755-766, 06.
  4. Cortazar, Gonzalo & Schwartz, Eduardo S. & Naranjo, Lorezo, 2003. "Term Structure Estimation in Low-Frequency Transaction Markets: A Kalman Filter Approach with Incomplete Panel-Data," University of California at Los Angeles, Anderson Graduate School of Management qt56h775cz, Anderson Graduate School of Management, UCLA.
  5. Gregory H. Bauer & Antonio Diez de los Rios, 2012. "An International Dynamic Term Structure Model with Economic Restrictions and Unspanned Risks," Working Papers 12-5, Bank of Canada.
  6. Georg Mosburger & Paul Schneider, 2005. "Modelling International Bond Markets with Affine Term Structure Models," Finance 0509003, EconWPA.
  7. Modugno, Michele & Nikolaou, Kleopatra, 2009. "The forecasting power of internal yield curve linkages," Working Paper Series 1044, European Central Bank.
  8. Gonzalo Cortazar & Eduardo S. Schwartz & Lorenzo F. Naranjo, 2007. "Term-structure estimation in markets with infrequent trading," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 12(4), pages 353-369.

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