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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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    Cited by:

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    2. 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.
    3. Branger, Nicole & Muck, Matthias & Seifried, Frank Thomas & Weisheit, Stefan, 2017. "Optimal portfolios when variances and covariances can jump," Journal of Economic Dynamics and Control, Elsevier, vol. 85(C), pages 59-89.
    4. Nicole Branger & Matthias Muck & Stefan Weisheit, 2019. "Correlation risk and international portfolio choice," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 39(1), pages 128-146, January.
    5. 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.
    6. Juneja, Januj, 2017. "Invariance, observational equivalence, and identification: Some implications for the empirical performance of affine term structure models," The Quarterly Review of Economics and Finance, Elsevier, vol. 64(C), pages 292-305.
    7. 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.

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    More about this item

    Keywords

    Term structure; Stochastic correlation; Risk premium; Wishart; Extended affine; Multidimensional CIR;
    All these keywords.

    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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