Quadratic Term Structure Models: Theory and Evidence

This article theoretically explores the characteristics underpinning quadratic term structure models (QTSMs), which designate the yield on a bond as a quadratic function of underlying state variables. We develop a comprehensive QTSM, which is maximally flexible and thus encompasses the features of s...

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Bibliographic Details
Published in:The Review of financial studies 2002, Vol.15 (1), p.243-288
Main Authors: Ahn, Dong-Hyun, Dittmar, Robert F., Gallant, A. Ronald
Format: Article
Language:English
Subjects:
Bonds
Correlations
Covariance matrices
Economic models
Finance
Financial performance
Financial risk
Interest rates
Market prices
Mathematical models
Modeling
Nominal interest rates
Parametric models
Prices
Stock prices
Stock returns
Studies
Variable interest rates
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Summary:This article theoretically explores the characteristics underpinning quadratic term structure models (QTSMs), which designate the yield on a bond as a quadratic function of underlying state variables. We develop a comprehensive QTSM, which is maximally flexible and thus encompasses the features of several diverse models including the double square-root model of Longstaff (1989), the univariate quadratic model of Beaglehole and Tenney (1992), and the squared-autoregressive-independent-variable nominal term structure (SAINTS) model of Constantinides (1992). We document a complete classification of admissibility and empirical identification for the QTSM, and demonstrate that the QTSM can overcome limitations inherent in affine term structure models (ATSMs). Using the efficient method of moments of Gallant and Tauchen (1996), we test the empirical performance of the model in determining bond prices and compare the performance to the ATSMs. The results of the goodness-of-fit tests suggest that the QTSMs outperform the ATSMs in explaining historical bond price behavior in the United States.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/15.1.243