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Nonlinearity in the Term Structure

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  • D H Kim
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    Abstract

    This paper investigates the nature of nonlinearities in the term structure using the flexible approach to nonlinear inference. The paper reports clear evidence of nonlinearity, in contrast to the affine term structure model and consistent with recent claims in the literature. We find that there is a threshold effect of volatility on the interest rate but this effect does not capture the entire nature of the nonlinearity. The quadratic term structure model recentlyproposed performs better for capturing the nonlinearity than the threshold model but the former model seems to miss some aspect of nonlinearity for short-term rates. However, our flexible nonlinear model which incorporates the threshold effect and the convexity of volatility into the quadratic model, generally performs well for all interest rates. The paper suggests that this model is a promising representation of nonlinearities and out-of-sample forecasts support the claim of nonlinearities.

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    File URL: http://www.socialsciences.manchester.ac.uk/medialibrary/cgbcr/discussionpapers/dpcgbcr51.pdf
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    Bibliographic Info

    Paper provided by Economics, The Univeristy of Manchester in its series Centre for Growth and Business Cycle Research Discussion Paper Series with number 51.

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    Length: 46 pages
    Date of creation: 2005
    Date of revision:
    Handle: RePEc:man:cgbcrp:51

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    1. Hamilton, James D & Kim, Dong Heon, 2002. "A Reexamination of the Predictability of Economic Activity Using the Yield Spread," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(2), pages 340-60, May.
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    3. Longstaff, Francis A., 1989. "A nonlinear general equilibrium model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 23(2), pages 195-224, August.
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    6. Gong, Fangxiong & Remolona, Eli M, 1997. "Two Factors along the Yield Curve," The Manchester School of Economic & Social Studies, University of Manchester, vol. 65(0), pages 1-31, Supplemen.
    7. Dong-Hyun Ahn & Robert F. Dittmar, 2002. "Quadratic Term Structure Models: Theory and Evidence," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 243-288, March.
    8. Dai, Qiang & Singleton, Kenneth J., 2002. "Expectation puzzles, time-varying risk premia, and affine models of the term structure," Journal of Financial Economics, Elsevier, vol. 63(3), pages 415-441, March.
    9. Brenner, Robin J. & Harjes, Richard H. & Kroner, Kenneth F., 1996. "Another Look at Models of the Short-Term Interest Rate," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(01), pages 85-107, March.
    10. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
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    16. Kim, Dong Heon & Denise R Osborn & Marianne Sensier, 2003. "Nonlinearity in the Fed's Monetary Policy Rule," Royal Economic Society Annual Conference 2003 121, Royal Economic Society.
    17. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
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    20. Hamilton, James D, 2001. "A Parametric Approach to Flexible Nonlinear Inference," Econometrica, Econometric Society, vol. 69(3), pages 537-73, May.
    21. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    22. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, vol. 52(4), pages 1287-1321, September.
    23. Hamilton, James D., 2003. "What is an oil shock?," Journal of Econometrics, Elsevier, vol. 113(2), pages 363-398, April.
    24. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
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