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How arbitrage-free is the Nelson–Siegel model under stochastic volatility?

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  • Takamizawa, Hideyuki

Abstract

This study examines the effect of no-arbitrage on the Nelson–Siegel (NS) model under stochastic interest-rate volatility. Unlike under constant volatility, in which only a constant (convexity-adjustment) term of a yield function differs with and without no-arbitrage, factor loadings also differ when the volatility is spanned by interest-rate factors. After controlling for the drift, we find that spanned volatility does not magnify the effect of no-arbitrage relative to constant volatility. The finding implies that enriching the NS model with stochastic volatility is of significant benefit as this better describes interest-rate data without increasing the cost of allowing arbitrage opportunities.

Suggested Citation

  • Takamizawa, Hideyuki, 2022. "How arbitrage-free is the Nelson–Siegel model under stochastic volatility?," International Review of Economics & Finance, Elsevier, vol. 79(C), pages 205-223.
    • Handle: RePEc:eee:reveco:v:79:y:2022:i:c:p:205-223
    DOI: 10.1016/j.iref.2022.01.011
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    More about this item

    Keywords

    Nelson–Siegel model; Yield curve; Interest rate; No-arbitrage; Stochastic volatility;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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