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Market Price of Risk Specifications for Affine Models: Theory and Evidence

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  • Patrick Cheridito
  • Damir Filipovic

Abstract

We extend the standard specification of the market price of risk for affine yield models of the term structure of interest rates, and estimate several models using the extended specification. For most models, the extended specification fits US data better than standard specifications, often with extremely high statistical significance. Our specification yields models that are affine under both objective and risk-neutral probability measures, but is never used in financial applications, probably because of the difficulty of applying traditional methods for proving the absence of arbitrage. Using an alternate method, we show that the extended specification does not permit arbitrage opportunities, provided that under both measures the state variables cannot achieve their boundary values. Likelihood ratio tests show our extension is statistically significant for four of the models considered at the conventional 95% confidence level, and at far higher levels for three of the models. The results are particularly strong for affine diffusions with multiple square-root type variables. Although we focus on affine yield models, our extended market price of risk specification also applies to any model in which Feller's square-root process or a multivariate extension is used to model asset prices.

Suggested Citation

  • Patrick Cheridito & Damir Filipovic, 2004. "Market Price of Risk Specifications for Affine Models: Theory and Evidence," Econometric Society 2004 North American Winter Meetings 536, Econometric Society.
  • Handle: RePEc:ecm:nawm04:536
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    References listed on IDEAS

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    Cited by:

    1. Caio Almeida & Jeremy J. Graveline & Scott Joslin, 2005. "Do Options Contain Information About Excess Bond Returns?," IBMEC RJ Economics Discussion Papers 2005-04, Economics Research Group, IBMEC Business School - Rio de Janeiro.
    2. Duffee, Gregory R., 2006. "Term structure estimation without using latent factors," Journal of Financial Economics, Elsevier, vol. 79(3), pages 507-536, March.

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    More about this item

    Keywords

    affine yield model; market price of risk; Feller process; maximum likelihood estimation;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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