Can Spanned Term Structure Factors Drive Stochastic Yield Volatility?

Author(s): Jens H.E. Christensen, Jose A. Lopez, and Glenn D. Rudebusch

The ability of the usual factors from empirical arbitrage-free representations of the term structure -- that is, spanned factors -- to account for interest rate volatility dynamics has been much debated. We examine this issue with a comprehensive set of new arbitrage-free term structure specifications that allow for spanned stochastic volatility to be linked to one or more of the yield curve factors. Using U.S. Treasury yields, we find that much realized stochastic volatility cannot be associated with spanned term structure factors. However, a simulation study reveals that the usual realized volatility metric is misleading when yields contain plausible measurement noise. We argue that other metrics should be used to validate stochastic volatility models

Download PDF (pdf, 820.23 kb)

Article Citation

Christensen, Jens H.E, Jose A. Lopez, and Glenn D. Rudebusch. 2014. "Can Spanned Term Structure Factors Drive Stochastic Yield Volatility?," Federal Reserve Bank of San Francisco Working Paper 2014-03. Available at https://doi.org/10.24148/wp2014-03