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Tractable Term Structure Models: A New Approach

date Date: October 1, 2015
date Author(s): Bruno Feunou, Jean-Sebastien Fontaine, Anh Le, Christian Lundblad
date Affiliation: Bank of Canada - Kenan-Flagler Business School - University of North Carolina at Chapel Hill
Abstract

We greatly expand the space of tractable term structure models (TTSM). We consider one example of TTSM with positive yields together with rich volatility and correlations dynamics. Bond prices can be expressed in closed-form and estimation is straightforward. We find that the early stages of a recession have distinct effects on yield volatility. Upon entering a recession when yields are far from the lower bound, (1) the volatility term structure becomes flatter, (2) the level and slope of yields are nearly uncorrelated, and (3) the second principle component of yields plays a larger role. However, these facts are significantly different when yields are close to the lower bound. Entering a recession in such a setting, (1) the volatility term structure instead steepens, (2) the level and slope factors are strongly correlated, and (3) the second principle component of yields plays a smaller role. Existing DTSMs do not capture the changes in the cyclical responses of the volatility term structure near the lower bound.

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