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Stochastic Correlation and Risk Premia in Term Structure Models

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Abstract
This paper proposes and analyses a term structure model that allows for both stochastic correlation between underlying factors and an extended market price of risk specification. The issues of invariant transformation and different normalization are then considered so that a comparison between different restrictions can be made. We show that significant improvement in bond fitting is obtained by both allowing the market price of risk to have an extended affine form, and allowing the correlation between underlying factors to be stochastic as well as of variable sign. The overall model fit is more negatively impacted by the restriction on the market price of risk than the restriction of correlated factors. However, the stochastic correlation is priced significantly by market participants, though its impact on the risk premia reduces gradually as time to maturity increases. In addition, stochastic correlation is vital in obtaining good hedged portfolio positions. Certainly, the best hedged portfolio is the one that is built based on the model that takes into account both stochastic correlation and extended market price of risk.

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  • Carl Chiarella & Chih-Ying Hsiao & Thuy-Duong To, 2011. "Stochastic Correlation and Risk Premia in Term Structure Models," Research Paper Series 298, Quantitative Finance Research Centre, University of Technology, Sydney.
    • Handle: RePEc:uts:rpaper:298
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    File URL: https://www.uts.edu.au/sites/default/files/qfr-archive-03/QFR-rp298.pdf
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    Cited by:

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    2. Da Fonseca, José & Gnoatto, Alessandro & Grasselli, Martino, 2013. "A flexible matrix Libor model with smiles," Journal of Economic Dynamics and Control, Elsevier, vol. 37(4), pages 774-793.
    3. Branger, Nicole & Muck, Matthias & Seifried, Frank Thomas & Weisheit, Stefan, 2017. "Optimal portfolios when variances and covariances can jump," Journal of Economic Dynamics and Control, Elsevier, vol. 85(C), pages 59-89.
    4. Nicole Branger & Matthias Muck & Stefan Weisheit, 2019. "Correlation risk and international portfolio choice," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 39(1), pages 128-146, January.
    5. Deelstra, Griselda & Grasselli, Martino & Van Weverberg, Christopher, 2016. "The role of the dependence between mortality and interest rates when pricing Guaranteed Annuity Options," Insurance: Mathematics and Economics, Elsevier, vol. 71(C), pages 205-219.
    6. Juneja, Januj, 2017. "Invariance, observational equivalence, and identification: Some implications for the empirical performance of affine term structure models," The Quarterly Review of Economics and Finance, Elsevier, vol. 64(C), pages 292-305.
    7. Alessandro Gnoatto & Martino Grasselli, 2013. "An analytic multi-currency model with stochastic volatility and stochastic interest rates," Papers 1302.7246, arXiv.org, revised Mar 2013.

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    More about this item

    Keywords

    Term structure; Stochastic correlation; Risk premium; Wishart; Affine; Extended affine; Multidimensional CIR;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation

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