Working Paper

Empirical tests of two state-variable HJM models

Abstract: Models for pricing interest rate claims, developed under the Heath-Jarrow-Morton paradigm, differ according to the volatility structure imposed on forward rates. For most general HJM structures the resultant path dependence creates implementation problems. Ritchken and Sankarasubramanian have recently identified necessary and sufficient conditions on the class of volatility structures of forward rates that enable the term structure dynamics to be captured by a finite set of state variables. The class is quite rich. The instantaneous spot rate volatility may be quite general, but the model curtails the structure of forward rate volatilities relative to this spot rate volatility. This paper provides empirical tests for this class of volatility structures. Unlike other studies, the volatility structure is examined over the a broad section of maturities in the yield curve. Using Treasury data over the period 1982-1994, we find support for this class. Furthermore, unlike other studies, no evidence of a \"volatility\" hump is identified.

Keywords: Financial markets; Interest rates;

Status: Published in Journal of Money, Credit, and Banking, August 1996

Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta Working Paper

Publication Date: 1995

Number: 95-13