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Risk premia, volatilities, and Sharpe ratios in a non-linear term structure model

Subject

Finance

Publishing details

Working Paper

Authors / Editors

Feldhutter P;Heyerdahl-Larsen C;Illeditsch P

Publication Year

2016

Abstract

We introduce a new reduced form term structure model where the short rate and market prices of risk are nonlinear functions of Gaussian state variables but yields are nevertheless given in closed form. Empirically, our three-factor nonlinear Gaussian model matches both the time-variation in expected excess returns and yield volatilities of U.S. Treasury bonds. During low volatility periods Treasury bonds are more attractive investments than standard Gaussian models predict. A significant part of expected excess returns in the nonlinear model is not explained by a linear combination of yields. This suggests that more information about expected excess returns is contained in the yield curve than previously thought, but in a nonlinear way.

Keywords

Nonlinear term structure models; Gaussian term structure models

Series

Working Paper

Available on ECCH

No


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