Interest Rate Volatility and No-Arbitrage Affine Term Structure Models

Scott Joslin () and Anh Le ()
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Scott Joslin: USC Marshall School of Business, University of Southern California, Los Angeles, California 90089
Anh Le: Smeal College of Business, Pennsylvania State University, University Park, Pennsylvania 16802

Management Science, 2021, vol. 67, issue 12, 7391-7416

Abstract: Within the affine framework, many have observed a tension between matching conditional first and second moments in dynamic term structure models (DTSMs). Although the existence of this tension is generally accepted, less understood is the mechanism that underlies it. We show that no arbitrage along with the rich information in the cross section of yields has strong implications for both the dynamics of volatility and the forecasts of yields. We show that this link implied by the absence of arbitrage—and not the factor structure per se—underlies the tension between first and second moments found in the literature. Adding to recent research that has suggested that no-arbitrage restrictions are nearly irrelevant in Gaussian DTSMs, our results show that no-arbitrage restrictions are potentially relevant when there is stochastic volatility.

Keywords: finance; asset pricing; investment; economics; econometrics; term structure models; interest rate; volatility (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:67:y:2021:i:12:p:7391-7416

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