TY - UNPB

T1 - Volatility-Induced Stationarity and Error-Correction in Macro-Finance Term Structure Modeling

AU - Hansen, Anne Lundgaard

PY - 2018/12/3

Y1 - 2018/12/3

N2 - It is well-known that interest rates and inflation rates are extremely persistent, yet they are best modeled and understood as stationary processes. These properties are contradictory in the workhorse Gaussian affine term structure model in which the persistent data often result in unit roots that imply non-stationarity. We resolve this puzzle by proposing a macro-finance term structure model with volatility-induced stationarity. Our model employs a level-dependent conditional volatility that maintains stationarity despite presence of unit roots in the characteristic polynomial corresponding to the conditional mean. Compared to the Gaussian affine term structure model, we improve out-of-sample forecasting of the yield curve and estimate term premia that are economically plausible and consistent with survey data. Moreover, we show that volatility-induced stationarity affects the error-correcting mechanism in a system of interest rates, inflation, and real activity.

AB - It is well-known that interest rates and inflation rates are extremely persistent, yet they are best modeled and understood as stationary processes. These properties are contradictory in the workhorse Gaussian affine term structure model in which the persistent data often result in unit roots that imply non-stationarity. We resolve this puzzle by proposing a macro-finance term structure model with volatility-induced stationarity. Our model employs a level-dependent conditional volatility that maintains stationarity despite presence of unit roots in the characteristic polynomial corresponding to the conditional mean. Compared to the Gaussian affine term structure model, we improve out-of-sample forecasting of the yield curve and estimate term premia that are economically plausible and consistent with survey data. Moreover, we show that volatility-induced stationarity affects the error-correcting mechanism in a system of interest rates, inflation, and real activity.

KW - Faculty of Social Sciences

KW - Yield curve

KW - error-correction

KW - unit root

KW - volatility-induced stationarity

KW - macro-finance term structure model

KW - evel-dependent conditional volatility

U2 - 10.2139/ssrn.3294960

DO - 10.2139/ssrn.3294960

M3 - Working paper

T3 - University of Copenhagen. Institute of Economics. Discussion Papers (Online)

BT - Volatility-Induced Stationarity and Error-Correction in Macro-Finance Term Structure Modeling

ER -