An International Examination of Affine Term Structure Models and the Expectations Hypothesis

Huarong Tang and Yihong Xia
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Huarong Tang: U of Pennsylvania

Working Papers from University of Pennsylvania, Wharton School, Weiss Center

Abstract: We examine the yield curve behavior and the relative performance of affine term structure models using government bond yield data from Canada, Germany, Japan, UK, and US. We find strong predictability of forward rates for excess bond returns and reject the expectations hypothesis across all five countries. A three-factor model is sufficient to capture movements in the yield curve of Canada, Japan, UK, and US, but may not be enough for Germany. An exhaustive comparison among affine term structure models with no more than three factors reveals that the three-factor essential affine model (A1(3)E) with only one factor affecting the volatility of the short rate but with all three factors affecting the price of risk performs best in all five countries. Simulations provide inconclusive evidence on whether this best affine model can successfully generate the rich yield curve behavior observed in the data.

Date: 2005-03
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