An Asset Pricing Approach to Testing General Term Structure Models including Heath-Jarrow-Morton Specifications and Affine Subclasses

Bent Jesper Christensen, Michel van der Wel

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    Abstract

    We develop a new empirical approach to term structure analysis that allows testing
    for time-varying risk premia and for the absence of arbitrage opportunities based on
    the drift restriction within the Heath, Jarrow and Morton (1992) framework. As in the
    equity case, a zero intercept condition is tested, but in addition to the standard bilinear
    term in factor loadings and market prices of risk, the relevant mean restriction in the
    term structure case involves an additional nonlinear (quadratic) term in factor loadings.
    We estimate our general model using likelihood-based dynamic factor model techniques
    for a variety of volatility factors, and implement the relevant likelihood ratio tests. Our
    factor model estimates are similar across a general state space implementation and
    an alternative robust two-step principal components approach. The evidence favors
    time-varying market prices of risk. Most of the risk premium is associated with the
    slope factor, and individual risk prices depend on own past values, factor realizations,
    and past values of other risk prices, and are significantly related to the output gap,
    consumption, and the equity risk price. The absence of arbitrage opportunities is
    strongly rejected with one or two factors in the model, but not with three or more
    factors.
    Original languageEnglish
    Place of publicationAarhus
    PublisherInstitut for Økonomi, Aarhus Universitet
    Number of pages48
    Publication statusPublished - 2010

    Keywords

    • arbitrage, bond aging effect, dynamic factor model, macroeconomic conditioning variables, nonlinear drift restriction, state space model, time-varying risk premia, yield curve model

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