A no-arbitrage affine term-structure model with macroeconomic and market factors and its empirical applications to the UK bond markets

Jayathilaka, Uhanowitage Suranjan Sadeeptha

Abstract

This study describes the joint dynamics of the U.K. risk-free government bonds and risky corporate bond yields using a large set of macroeconomic and market variables. In this context, the thesis develops for the new understanding of the determination of the yield curve and contributes to the literature in three ways. First, this study introduces and consistently estimates a no-arbitrage affine term­structure model which takes fll advantage of a data rich environment and disentangles the individual effects of the factors driving the risk-free term structure of interest rates and credit spreads. The study incorporates three observable risk dimensions, the traditionally studied variables of real activity and inflation, together with a novel factor which represents financial market activity. The empirical results indicate that the impact of the market factor is comparable in absolute value to the impact of the inflation and the real activity factors at medium and long-term maturities of risk-free yields and also corporate credit spreads. At short maturities, the market factor is at least as important as inflation but less important than real activity. For corporate credit spreads, the impact of the market factor is more pronounced at short and long maturities for lower-rated BBB bonds and at short and medium maturities for higher-rated A bonds. Also, the influence of both macroeconomic and market activity is more pronounced in corporate bond credit spreads than in risk-free gilts.
Second, the empirical analysis in this study confirms, in line with earlier studies, that the market prices of risk vary considerably over time. The results also indicate that the market price of real activity risk tends to be negative, whereas the market price of inflation risk is close to zero, on average, and the price of market risk is positive.
Finally, this compares the out-of-sample forecasting performance of the proposed model with five other competitor models drawn from the literature for the U.K. risk-free bond yields. The forecasting exercise is conducted separately over three sub-periods containing the pre-crisis, crisis and post-crisis period that feature rich term structure dynamics with highly volatile risk-free yields. The proposed model outperforms the competitor no-arbitrage models and forecasts particularly well yields at short and long maturities for all forecast horizons.

Citation

Jayathilaka, U. S. S. (2016). A no-arbitrage affine term-structure model with macroeconomic and market factors and its empirical applications to the UK bond markets

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