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

Finance

Working Paper

2016

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.

Nonlinear term structure models; Gaussian term structure models

Working Paper

No

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