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Market-Based Solutions to Vital Economic Issues
Research
Dec 1, 2015

Tractable Term Structure Models and the Zero Lower Bound

Abstract

We greatly expand the space of tractable term structure models (TTSM). We consider one example of TTSM with positive yields together with rich volatility and correlations dynamics. Bond prices can be expressed in closed-form and estimation is straightforward. We find that the early stages of a recession have distinct effects on yield volatility. Upon entering a recession when yields are far from the lower bound, (1) the volatility term structure becomes flatter, (2) the level and slope of yields are nearly uncorrelated, and (3) the second principle component of yields plays a larger role. However, these facts are significantly different when yields are close to the lower bound. Entering a recession in such a setting, (1) the volatility term structure instead steepens, (2) the level and slope factors are strongly correlated, and (3) the second principle component of yields plays a smaller role. Existing DTSMs do not capture the changes in the cyclical responses of the volatility term structure near the lower bound.

Note: Research papers posted on SSRN, including any findings, may differ from the final version chosen for publication in academic journals.


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