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Time-Consistent No-Arbitrage Models of the Term Structure

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Author Info
Michael W. Brandt
Amir Yaron

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Abstract

We present an econometric procedure for calibrating no-arbitrage term structure models in a way that is time-consistent and robust to measurement errors. Typical no-arbitrage models are time-inconsistent because their parameters are assumed constant for pricing purposes despite the fact that the parameters change whenever the model is recalibrated. No-arbitrage models are also sensitive to measurement errors because they fit exactly each potentially contaminated bond price in the cross-section. We overcome both problems by evaluating bond prices using the joint dynamics of the factors and calibrated parameters and by locally averaging out the measurement errors. Our empirical application illustrates the trade-off between fitting as well as possible and overfitting the cross-section of bond prices due to measurement errors. After optimizing this trade-off, our approach fits almost exactly the cross-section of bond prices at each date and produces out-of-sample forecast errors that beat a random walk benchmark and are comparable to the results in the affine term structure literature. We find that non-linearities in the pricing kernel are important, lending support to quadratic term structure models.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9458.

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Date of creation: Jan 2003
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Handle: RePEc:nbr:nberwo:9458

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G0 - Financial Economics - - General

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References listed on IDEAS
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Markus Leippold & Liuren Wu, 2002. "Asset Pricing Under The Quadratic Class," Finance 0207015, EconWPA. [Downloadable!]
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  2. Konstantijn Maes, 2004. "Modeling the Term Structure of Interest Rates: Where Do We Stand?," Research series 200402, National Bank of Belgium. [Downloadable!]
    Other versions:
  3. Francis X. Diebold & Canlin Li, 2004. "Forecasting the Term Structure of Government Bond Yields," CFS Working Paper Series 2004/09, Center for Financial Studies. [Downloadable!]
    Other versions:
  4. Gomes, Joao F & Yaron, Amir & Zhang, Lu, 2002. "Asset Pricing Implications of Firms' Financing Constraints," CEPR Discussion Papers 3495, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  5. Enlin Pan & Liuren Wu, 2004. "Taking Positive Interest Rates Seriously," Finance 0409013, EconWPA. [Downloadable!]
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