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Affine and quadratic models with many factors and few parameters

Marco Realdon

The European Journal of Finance, Pages: 1 - 28

Swansea University Author: Marco Realdon

Abstract

"Classic" affine and quadratic term structure models in the literature usually have three or four factors and tens of parameters. However affine and quadratic term structure models with many factors and few parameters (MFFP), i.e. with up to twenty factors and with six to seven parameters,...

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Published in: The European Journal of Finance
ISSN: 1351-847X 1466-4364
Published: Informa UK Limited
Online Access: Check full text

URI: https://cronfa.swan.ac.uk/Record/cronfa52889
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Abstract: "Classic" affine and quadratic term structure models in the literature usually have three or four factors and tens of parameters. However affine and quadratic term structure models with many factors and few parameters (MFFP), i.e. with up to twenty factors and with six to seven parameters, fit and predict US and Euro sovereign yields betterthan "classic" affine and quadratic models. MFFP models also fit the volatility of and the correlations between changes in yields of different maturities better than "classic" models. MFFP models outperform because fewer parameters reduce in sample over-fitting and because more factors give models more flexibility to match yields of different maturities. Among MFFP models, a type of affine model with stochastic volatility is usually preferable to homoschedastic affine models, but for US yields the quadratic model seems preferable among five factor MFFP models.
Keywords: affine term structure models, quadratic term structure models, discrete time, squared Gaussian shocks, Giacomini-White tests.
Start Page: 1
End Page: 28