 An Affine Term Structure Model with Auxiliary Stochastic VolatilityCovolatility
 Linlin Niu

 #002015 20131014 (published)
 This paper proposes an affine term structure model in a stochastic volatility setting. It provides a useful modeling tool to bridge the two strands of macroeconomic and finance research: the DSGEVAR with stochastic volatility and the macrofinance model of term structure. In the model, the state vector follows a VAR; its innovations are conditional normal with a timevarying variancecovariance following a Wishart Autoregression process, which directly drives the risk price in the stochastic discount factor. In this setting, the yield curve under noarbitrage is determined both by the state vector and its stochastic volatilitycovolatility matrix. A DSGEVAR with stochastic volatility can readily be cast into the state of this term structure model. Simulation of the baseline model shows that: 1) two factors are sufficient to fully reproduce all typical shapes of the yield curve; 2) Volatility and Covolatility has sizable effect on medium to long maturity yields; 3) volatility is a curvature factor of the yield curve, and the net effect of a multivariate variancecovariance matrix is also a curvature factor; 4) expected excess returns are explicitly linked to the volatilitycovolatility of state innovations; 5) the model can well explain the bond yield "conundrum" in 20042005, where the long term interest rate remains low while short term rate keeps rising continuously.
 JELCodes: G12, E43
 Keywords: Term structure, Stochastic volatility, Wishart Autoregressive process
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