Working Paper: CEPR ID: DP2065
Authors: Frank de Jong
Abstract: In this paper we provide an empirical analysis of the term structure of interest rates using the affine class of term structure models introduced by Duffie and Kan. We estimate these models by combining time-series and cross-section information in a theoretically consistent way. In the estimation we use an exact discretization of the continuous time factor process and allow for a general measurement error structure. We provide evidence that a three factor affine model with correlated factors is able to provide an adequate fit of the cross section and the dynamics of the term structure. The three factors can be given the usual interpretation of level, steepness and curvature. The shocks to these factors are significantly correlated.
Keywords: term structure; panel data; kalman filter
JEL Codes: C33; E43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| three-factor affine model (C51) | adequate fit for the cross-section and dynamics of the term structure (C50) |
| factors representing level, steepness, and curvature (C51) | significantly correlated (C10) |
| shocks to these factors (F31) | direct relationship with observed interest rates (E43) |
| one-factor model (C20) | fails to capture the volatility of short-term interest rates (E43) |
| two-factor model (G41) | captures the level and slope effectively but struggles with medium-range maturities (E43) |
| introduction of a third curvature factor (Y20) | resolves issues with the two-factor model (C38) |
| three-factor model (C38) | captures the observed yield curve's shape well (E43) |
| risk premiums associated with the factors (G12) | significant (C20) |