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How arbitrage-free is the Nelson–Siegel model under stochastic volatility?

Hideyuki Takamizawa

International Review of Economics & Finance, 2022, vol. 79, issue C, 205-223

Abstract: This study examines the effect of no-arbitrage on the Nelson–Siegel (NS) model under stochastic interest-rate volatility. Unlike under constant volatility, in which only a constant (convexity-adjustment) term of a yield function differs with and without no-arbitrage, factor loadings also differ when the volatility is spanned by interest-rate factors. After controlling for the drift, we find that spanned volatility does not magnify the effect of no-arbitrage relative to constant volatility. The finding implies that enriching the NS model with stochastic volatility is of significant benefit as this better describes interest-rate data without increasing the cost of allowing arbitrage opportunities.

Keywords: Nelson–Siegel model; Yield curve; Interest rate; No-arbitrage; Stochastic volatility (search for similar items in EconPapers)
JEL-codes: C58 E43 E47 G17 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1016/j.iref.2022.01.011

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