An Affine Model for International Bond Markets

Hans Dewachter and Konstantijn Maes ()

International Economics Working Papers Series from Katholieke Universiteit Leuven, Centrum voor Economische Studiën, International Economics

Abstract: We present and estimate a parsimonious multi-factor affine term structure model for joint bond markets. We extend the standard affine models by focusing on joint markets and by incorporating the exchange rate dynamics in the estimation procedure. Estimation is done by means of a Kalman filter algorithm. We find that our particular three factor model is quite successful in fitting bond correlations, both within and between national bond markets. Moreover, the model sheds light on some of the most persistent puzzles in empirical finance. Finally, we apply the model to test for international diversification gains in unhedged bond portfolios, conditional on the information that is present in the term structures of both countries. We find that exchange rate risk is sufficiently priced such that the inclusion of foreign bonds allows for an improved risk-return trade off from the perspective of a domestic investor.

Keywords: forward premium anomaly; affine joint term structure model; kalman filter (search for similar items in EconPapers)
JEL-codes: C22 C33 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2001-02
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Citations: View citations in EconPapers (3)

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Working Paper: An Affine Model for International Bond Markets (2001)
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