Qiang Dai, Kenneth J. Singleton
ABSTRACT
In this paper, we explore the features of affine term structure models
that are empirically important for explaining the joint distribution of
yields on short and long-term interest rate swaps. We begin by showing
that the family of N-factor affine models can be classified into N+1
non-nested sub-families of models. For each sub-family, we derive a
maximal model with the property that every admissible member of this
family is equivalent to or a nested special case of our maximal model.
Second, using our classification scheme and maximal models, we show that
many of the three-factor models in the literature impose potentially
strong over-identifying restrictions on the joint distribution of short-
and long-term rates. Third, we compute simulated method-of-moments
estimates for several members of one of the four branches of three-factor
models, and test the over-identifying restrictions implied by these
models. We conclude that many of the extant affine models in the
literature fail to describe important features of the distribution of
long- and short- term rates. The source of the model misspecification is
shown to be overly strong restrictions on the correlations among the state
variables. Relaxing these restrictions leads to a model that passes
several goodness-of-fit tests over our sample period.
Subject: Investment/Fixed Income(Empirical, Theoretical)
Dai: (212) 998-0358
gdai@stern.nyu.edu
Singleton: (650) 723-5753
ken@future.stanford.edu
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