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An International Examination of Affine Term Structure Models and the Expectations Hypothesis

Published online by Cambridge University Press:  06 April 2009

Huarong Tang  and
Yihong Xia
Huarong Tang
Affiliation:
huarong.tang@lehman.com, Fixed Income Research, Lehman Brothers International, 25 Bank Street, London, E14 5LE, U.K.
Yihong Xia
Affiliation:
The Finance Department, the Wharton School, University of Pennsylvania, passed away in August 2005.
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Abstract

We examine the yield curve behavior and the relative performance of affine term structure models (ATSMs) using government bond yield data from Canada, Germany, Japan, the U.K., and the U.S. We find strong predictability of forward rates for excess bond returns and reject the expectations hypothesis in all five countries. A three-factor model is sufficient to capture movements in the yield curve of Canada, Japan, the U.K., and the U.S., but may not be enough for Germany. An exhaustive comparison among ATSMs with no more than three factors reveals that the three-factor essential affine model (A1(3)E), with only one factor affecting the volatility of the short rate but with all three factors affecting the price of risk, performs best in all five countries. Simulations provide inconclusive evidence on whether this best affine model can successfully generate the rich yield curve behavior observed in the data.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 42 , Issue 1 , March 2007 , pp. 41 - 80
Copyright
Copyright © School of Business Administration, University of Washington 2007

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