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Stochastic correlation and risk premia in term structure models

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  • Chiarella, Carl
  • Hsiao, Chih-Ying
  • Tô, Thuy-Duong

Abstract

This paper analyzes a term structure model that allows for both stochastic correlation between underlying factors and an extended market price of risk specification. We show that significant improvement in bond fitting and portfolio performance is obtained by the model. However, the restriction on market price of risk has a more negative impact on bond price fitting and forecasting, whereas the restriction on correlated factors has a more negative impact on hedging performance. The model has good predictive power for bond risk premia. Once our model factors are taken into account, other predictive factors become insignificant.

Suggested Citation

  • Chiarella, Carl & Hsiao, Chih-Ying & Tô, Thuy-Duong, 2016. "Stochastic correlation and risk premia in term structure models," Journal of Empirical Finance, Elsevier, vol. 37(C), pages 59-78.
  • Handle: RePEc:eee:empfin:v:37:y:2016:i:c:p:59-78
    DOI: 10.1016/j.jempfin.2016.02.003
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    References listed on IDEAS

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    Cited by:

    1. repec:eee:dyncon:v:85:y:2017:i:c:p:59-89 is not listed on IDEAS
    2. Deelstra, Griselda & Grasselli, Martino & Van Weverberg, Christopher, 2016. "The role of the dependence between mortality and interest rates when pricing Guaranteed Annuity Options," Insurance: Mathematics and Economics, Elsevier, vol. 71(C), pages 205-219.
    3. repec:eee:quaeco:v:64:y:2017:i:c:p:292-305 is not listed on IDEAS
    4. Da Fonseca, José & Gnoatto, Alessandro & Grasselli, Martino, 2013. "A flexible matrix Libor model with smiles," Journal of Economic Dynamics and Control, Elsevier, vol. 37(4), pages 774-793.
    5. Alessandro Gnoatto & Martino Grasselli, 2013. "An analytic multi-currency model with stochastic volatility and stochastic interest rates," Papers 1302.7246, arXiv.org, revised Mar 2013.

    More about this item

    Keywords

    Term structure; Stochastic correlation; Risk premium; Wishart; Extended affine; Multidimensional CIR;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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