Department of Economics and Business Economics

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

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  • School of Economics and Management
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
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages48
Publication statusPublished - 2010

    Research areas

  • 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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