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Time-Consistent No-Arbitrage Models of the Term Structure

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  • Michael W. Brandt
  • Amir Yaron

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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Bibliographic Info

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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Cited by:
  1. Leippold, Markus & Wu, Liuren, 2002. "Asset Pricing under the Quadratic Class," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(02), pages 271-295, June.
  2. Joao Gomes & Amir Yaron & Lu Zhang, 2002. "Asset Pricing Implications of Firms' Financing Constraints," NBER Working Papers 9365, National Bureau of Economic Research, Inc.
  3. Konstantijn Maes, 2004. "Modeling the Term Structure of Interest Rates: Where Do We Stand?," Working Paper Research 42, National Bank of Belgium.
  4. Francis X. Diebold & Canlin Li, 2004. "Forecasting the Term Structure of Government Bond Yields," CFS Working Paper Series 2004/09, Center for Financial Studies.
  5. Hans Dewachter, 2008. "Imperfect information, macroeconomic dynamics and the yield curve : an encompassing macro-finance model," Working Paper Research 144, National Bank of Belgium.
  6. Tatyana Krivobokova & Göran Kauermann & Theofanis Archontakis, 2006. "Estimating the term structure of interest rates using penalized splines," Statistical Papers, Springer, vol. 47(3), pages 443-459, June.
  7. Enlin Pan & Liuren Wu, 2004. "Taking Positive Interest Rates Seriously," Finance 0409013, EconWPA.

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