An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates

AbstractThis paper suggests a new empirical methodology of testing the predictions of the term spread between long and short-term interest rates about future changes of the former allowing for term premium effects, according to the rational expectations hypothesis of the term structure. To capture the effects of a time-varying term premium on the term spread, the paper relies on an empirically attractive affine Gaussian dynamic term structure model which assumes that the term structure of interest rates is spanned by three unobserved state variables. To retrieve accurate values of these variables from interest rates series, the paper suggests a new method which can overcome the effects of measurement (or pricing) errors inherent in these series on the estimates of the model. This method is assessed by a Monte Carlo study. Ignoring these errors will lead to biased estimates of term structure models. The empirical results of the paper provide support for the suggested term structure model. They show that this model can efficiently capture the time-varying term premium effects embodied in long-term interest rates, which can explain the failures of term spread to forecast future changes in long-term rates.

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A Three-Factor Defaultable Term Structure Model

Springer Finance - Credit Risk Pricing Models ◽

10.1007/978-3-540-24716-6_6 ◽

2004 ◽

pp. 179-325

Author(s):

Bernd Schmid

Keyword(s):

Term Structure ◽

Structure Model ◽

Term Structure Model ◽

Three Factor

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A Quantum Field Theory Term Structure Model Applied to Hedging

International Journal of Theoretical and Applied Finance ◽

10.1142/s0219024903001980 ◽

2003 ◽

Vol 06 (05) ◽

pp. 443-467 ◽

Cited By ~ 5

Author(s):

Belal E. Baaquie ◽

Marakani Srikant ◽

Mitch C. Warachka

Keyword(s):

Field Theory ◽

Quantum Field Theory ◽

Term Structure ◽

Theory Model ◽

Forward Rate ◽

Quantum Field ◽

Structure Model ◽

Term Structure Model ◽

Forward Rates ◽

Low Dimensional

A quantum field theory generalization, Baaquie [1], of the Heath, Jarrow and Morton (HJM) [10] term structure model parsimoniously describes the evolution of imperfectly correlated forward rates. Field theory also offers powerful computational tools to compute path integrals which naturally arise from all forward rate models. Specifically, incorporating field theory into the term structure facilitates hedge parameters that reduce to their finite factor HJM counterparts under special correlation structures. Although investors are unable to perfectly hedge against an infinite number of term structure perturbations in a field theory model, empirical evidence using market data reveals the effectiveness of a low dimensional hedge portfolio.

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A Three-Factor Defaultable Term Structure Model

The Journal of Fixed Income ◽

10.3905/jfi.2000.319265 ◽

2000 ◽

Vol 10 (2) ◽

pp. 63-79 ◽

Cited By ~ 8

Author(s):

Bernd Schmid ◽

Rudi Zagst

Keyword(s):

Term Structure ◽

Structure Model ◽

Term Structure Model ◽

Three Factor

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Term Structure Forecasts of Long-Term Consumption Growth

Journal of Financial and Quantitative Analysis ◽

10.1017/s0022109000002295 ◽

2005 ◽

Vol 40 (2) ◽

pp. 241-258 ◽

Cited By ~ 11

Author(s):

Andrea Berardi ◽

Walter Torous

Keyword(s):

Term Structure ◽

Structure Data ◽

Growth Rates ◽

Structure Model ◽

Sample Period ◽

State Variables ◽

Consumption Growth ◽

Term Structure Model ◽

Term Spread

AbstractRelying on a simple general equilibrium model of the term structure, we show that both nominal yields and real consumption growth rates can be affine in the unobservable state variables. We can then express real consumption growth rates in terms of nominal yields rather than the unobservable state variables with the coefficients of the resultant forecasting relation being endogenously determined by the term structure model. Using term structure data over the 1985 to 2000 sample period, the empirical evidence is consistent with our model more accurately predicting real consumption growth rates than a regression model based on the term spread.

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