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Unspanned stochastic volatility in the linear-rational square-root model: Evidence from the Treasury market

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  • Hansen, Jorge Wolfgang

Abstract

This study examines the ability of the linear-rational square-root model to simultaneously capture cross-sectional and time-series dynamics of bond yields and their variances. The preferred model specification comprises five factors, two of which are not spanned by the yield curve, introducing unspanned stochastic volatility (USV). This specification provides a close in-sample fit to yields and yield variances, emphasizing the need for USV. Out-of-sample testing demonstrates low variance forecast errors. The specification provides evidence of USV in conditional yield variance and bond risk premia, linked to macroeconomic uncertainty.

Suggested Citation

  • Hansen, Jorge Wolfgang, 2025. "Unspanned stochastic volatility in the linear-rational square-root model: Evidence from the Treasury market," Journal of Banking & Finance, Elsevier, vol. 171(C).
    • Handle: RePEc:eee:jbfina:v:171:y:2025:i:c:s0378426624002681
    DOI: 10.1016/j.jbankfin.2024.107354
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    More about this item

    Keywords

    Interest rate model; Treasury market; Unscented Kalman filter; Unspanned stochastic volatility; Unspanned risk premia;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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