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Term Premia and Interest Rate Forecasts in Affine Models
Author(s) -
Duffee Gregory R.
Publication year - 2002
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/1540-6261.00426
Subject(s) - affine transformation , interest rate , treasury , econometrics , volatility (finance) , rendleman–bartter model , risk premium , short rate model , economics , risk compensation , short rate , mathematics , yield curve , finance , medicine , archaeology , family medicine , human immunodeficiency virus (hiv) , pure mathematics , history
The standard class of affine models produces poor forecasts of future Treasury yields. Better forecasts are generated by assuming that yields follow random walks. The failure of these models is driven by one of their key features: Compensation for risk is a multiple of the variance of the risk. Thus risk compensation cannot vary independently of interest rate volatility. I also describe a broader class of models. These aessentially affine‐ models retain the tractability of standard models, but allow compensation for interest rate risk to vary independently of interest rate volatility. This additional flexibility proves useful in forecasting future yields.