Design and Estimation of Quadratic Term Structure Models

Markus Leippold () and Liuren Wu

Review of Finance, 2003, vol. 7, issue 1, 47-73

Abstract: We consider the design and estimation of quadratic term structure models. We start with a list of stylized facts on interest rates and interest rate derivatives, classified into three layers: (1) general statistical properties, (2) forecasting relations, and (3) conditional dynamics. We then investigate the implications of each layer of property on model design and strive to establish a mapping between evidence and model structures. We calibrate a two-factor model that approximates these three layers of properties well, and show that a flexible specification for the market price of risk is important in capturing the stylized evidence in forecasting relations while factor interactions are indispensable in generating the hump-shaped dynamics of bond yields. JEL classification codes: G12, G13, E43.

Date: 2003
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