Stochastic Volatilities and Correlations of Bond Yields



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    • Han is from the McCombs School of Business at the University of Texas, Austin. I am grateful to Martin Dierker, Heber Farnsworth, Mark Grinblatt, Jean Helwege, Jason Hsu, Jingzhi Huang, Christopher Jones, Andrew Karolyi, Francis Longstaff, Monika Piazzesi, Pedro Santa-Clara, Robert Stambaugh, Kenneth Singleton, an anonymous referee, and seminar participants at the Ohio State University for many useful comments. All errors are my own. Financial support from the Dice Center for Financial Economics at the Ohio State University is acknowledged.


I develop an interest rate model with separate factors driving innovations in bond yields and their covariances. It features a flexible and tractable affine structure for bond covariances. Maximum likelihood estimation of the model with panel data on swaptions and discount bonds implies pricing errors for swaptions that are almost always lower than half of the bid–ask spread. Furthermore, market prices of interest rate caps do not deviate significantly from their no-arbitrage values implied by the swaptions under the model. These findings support the conjectures of Collin-Dufresne and Goldstein (2003), Dai and Singleton (2003), and Jagnnathan, Kaplin, and Sun (2003).