A Term Structure Model of Interest Rates with Quadratic Volatility

Hideyuki Takamizawa and 秀幸 高見澤

No G-1-18, Working Paper Series from Hitotsubashi University Center for Financial Research

Abstract: This study proposes a no-arbitrage term structure model that can capture the volatility of interest rates without sacrificing the goodness-of-_t to the cross-section and predictive ability about the level of interest rates. The key feature of the model is the covariance matrix of changes in factors, which is specified as quadratic functions of factors. The quadratic specification can capture intense volatility even with spanned factors, which is not the case for the affine specification. Furthermore, since the quadratic specification guarantees the positive definiteness of the covariance matrix without restricting the sign of factors, it allows for a flexible specification of the physical drift as does the Gaussian term structure model, contributing also to accurate level prediction.

Keywords: Term structure; Interest rate; Volatility; Affine model; Prediction (search for similar items in EconPapers)
JEL-codes: C58 E43 G12 G17 (search for similar items in EconPapers)
Pages: 52 pages
Date: 2017-12-09
New Economics Papers: this item is included in nep-mac and nep-ore
Note: This draft: December 9, 2017
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https://hermes-ir.lib.hit-u.ac.jp/hermes/ir/re/28986/070hcfrWP_1_018.pdf

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Persistent link: https://EconPapers.repec.org/RePEc:hit:hcfrwp:g-1-18

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