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Yield Curve Factors, Term Structure Volatility, and Bond Risk Premia

  • Nikolaus Hautsch
  • Yangguoyi Ou

We introduce a Nelson-Siegel type interest rate term structure model with the underlying yield factors following autoregressive processes revealing time-varying stochastic volatility. The factor volatilities capture risk inherent to the term struc- ture and are associated with the time-varying uncertainty of the yield curve’s level, slope and curvature. Estimating the model based on U.S. government bond yields applying Markov chain Monte Carlo techniques we find that the yield factors and factor volatilities follow highly persistent processes. Using the extracted factors to explain one-year-ahead bond excess returns we observe that the slope and cur- vature yield factors contain the same explanatory power as the return-forecasting factor recently proposed by Cochrane and Piazzesi (2005). Moreover, we identify slope and curvature risk as important additional determinants of future excess returns. Finally, we illustrate that the yield and volatility factors are closely con- nected to variables reflecting macroeconomic activity, inflation, monetary policy and employment growth. It is shown that the extracted yield curve components have long-term prediction power for macroeconomic fundamentals.

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Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2008-053.

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Length: 47 pages
Date of creation: Jul 2008
Date of revision:
Handle: RePEc:hum:wpaper:sfb649dp2008-053
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  1. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
  2. Shiller, Robert & Campbell, John, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Scholarly Articles 3221490, Harvard University Department of Economics.
  3. Francis X. Diebold & Monika Piazzesi & Glenn D. Rudebusch, 2005. "Modeling Bond Yields in Finance and Macroeconomics," PIER Working Paper Archive 05-008, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  4. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
  5. Francis X. Diebold & Canlin Li, 2002. "Forecasting the Term Structure of Government Bond Yields," Center for Financial Institutions Working Papers 02-34, Wharton School Center for Financial Institutions, University of Pennsylvania.
  6. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  7. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  8. Hull, John & White, Alan, 1990. "Valuing Derivative Securities Using the Explicit Finite Difference Method," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(01), pages 87-100, March.
  9. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc.
  10. Francis X. Diebold & Glenn D. Rudebusch & S. Boragan Aruoba, 2004. "The Macroeconomy and the Yield Curve: A Dynamic Latent Factor Approach," NBER Working Papers 10616, National Bureau of Economic Research, Inc.
  11. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  12. Dai, Qiang & Singleton, Kenneth J., 2002. "Expectation puzzles, time-varying risk premia, and affine models of the term structure," Journal of Financial Economics, Elsevier, vol. 63(3), pages 415-441, March.
  13. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, vol. 60(1), pages 77-105, January.
  14. Robert F. Engle & Victor K. Ng, 1991. "Time-Varying Volatility and the Dynamic Behavior of the Term Structure," NBER Working Papers 3682, National Bureau of Economic Research, Inc.
  15. Robert F. Engle & Victor Ng & Michael Rothschild, 1988. "Asset Pricing with a Factor Arch Covariance Structure: Empirical Estimates for Treasury Bills," NBER Technical Working Papers 0065, National Bureau of Economic Research, Inc.
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