Interest Rate Volatility and No-Arbitrage Affine Term Structure Models

Scott Joslin, Anh Le

Research output: Contribution to journalArticlepeer-review

4 Scopus citations

Abstract

Within the affine framework, many have observed a tension between matching conditional first and second moments in dynamic term structure models (DTSMs). Although the existence of this tension is generally accepted, less understood is the mechanism that underlies it. We show that no arbitrage along with the rich information in the cross section of yields has strong implications for both the dynamics of volatility and the forecasts of yields. We show that this link implied by the absence of arbitrage-and not the factor structure per se-underlies the tension between first and second moments found in the literature. Adding to recent research that has suggested that no-arbitrage restrictions are nearly irrelevant in Gaussian DTSMs, our results show that no-arbitrage restrictions are potentially relevant when there is stochastic volatility.

Original languageEnglish (US)
Pages (from-to)7391-7416
Number of pages26
JournalManagement Science
Volume67
Issue number12
DOIs
StatePublished - Dec 2021

All Science Journal Classification (ASJC) codes

  • Strategy and Management
  • Management Science and Operations Research

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