DP2034 Direct Estimation of the Risk Neutral Factor Dynamics of Affine Term Structure Models

Author(s): Dennis Bams, Peter C Schotman
Publication Date: December 1998
Keyword(s): affine models, factor models, Panel Data, Term Structure of Interest Rates
JEL(s): C33, G13
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2034

This paper proposes a panel data framework for tests of affine models of the term structure of interest rates which cover equilibrium (or endogenous) models as well as extended (or exogenous, evolutionary) models. The econometric model pools yield curve data for different moments in time. Since each cross-sectional yield curve only depends on the risk neutral factor dynamics, the estimator does not involve any assumptions on the price of risk, or on actual interest rate dynamics. In the empirical application one and two factor Gaussian models are tested on US interest rate data. The main empirical results are: (i) that a two-factor model cannot be rejected; (ii) that mean reversion is highly significant; and (iii) that the extended models are 'over-differenced'.