Risk Premia and Volatilities in a Nonlinear Term Structure Model

Peter Feldhütter; Christian Heyerdahl-Larsen; Philipp Illeditsch

doi:10.1093/rof/rfw052

Risk Premia and Volatilities in a Nonlinear Term Structure Model

Peter Feldhütter, Christian Heyerdahl-Larsen, Philipp Illeditsch

Department of Finance

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Abstract

We introduce a reduced-form term structure model with closed-form solutions for yields where the short rate and market prices of risk are nonlinear functions of Gaussian state variables. The nonlinear model with three factors matches the time-variation in expected excess returns and yield volatilities of US Treasury bonds from 1961 to 2014. Yields and their variances depend on only three factors, yet the model exhibits features consistent with Unspanned Risk Premia (URP) and Unspanned Stochastic Volatility (USV).

Original language	English
Journal	Review of Finance
Volume	22
Issue number	1
Pages (from-to)	337–380
Number of pages	44
ISSN	1572-3097
DOIs	https://doi.org/10.1093/rof/rfw052
Publication status	Published - Feb 2018

Keywords

Nonlinear term structure models
Expected excess returns
Stochastic volatility
Unspanned risk premia
Unspanned stochastic volatility

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Cite this

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abstract = "We introduce a reduced-form term structure model with closed-form solutions for yields where the short rate and market prices of risk are nonlinear functions of Gaussian state variables. The nonlinear model with three factors matches the time-variation in expected excess returns and yield volatilities of US Treasury bonds from 1961 to 2014. Yields and their variances depend on only three factors, yet the model exhibits features consistent with Unspanned Risk Premia (URP) and Unspanned Stochastic Volatility (USV).",

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AU - Feldhütter, Peter

AU - Heyerdahl-Larsen, Christian

AU - Illeditsch, Philipp

PY - 2018/2

Y1 - 2018/2

N2 - We introduce a reduced-form term structure model with closed-form solutions for yields where the short rate and market prices of risk are nonlinear functions of Gaussian state variables. The nonlinear model with three factors matches the time-variation in expected excess returns and yield volatilities of US Treasury bonds from 1961 to 2014. Yields and their variances depend on only three factors, yet the model exhibits features consistent with Unspanned Risk Premia (URP) and Unspanned Stochastic Volatility (USV).

AB - We introduce a reduced-form term structure model with closed-form solutions for yields where the short rate and market prices of risk are nonlinear functions of Gaussian state variables. The nonlinear model with three factors matches the time-variation in expected excess returns and yield volatilities of US Treasury bonds from 1961 to 2014. Yields and their variances depend on only three factors, yet the model exhibits features consistent with Unspanned Risk Premia (URP) and Unspanned Stochastic Volatility (USV).

KW - Nonlinear term structure models

KW - Expected excess returns

KW - Stochastic volatility

KW - Unspanned risk premia

KW - Unspanned stochastic volatility

KW - Nonlinear term structure models

KW - Expected excess returns

KW - Stochastic volatility

KW - Unspanned risk premia

KW - Unspanned stochastic volatility

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DO - 10.1093/rof/rfw052

M3 - Journal article

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JO - Review of Finance

JF - Review of Finance

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