A portfolio-based evaluation of affine term structure models

We focus on affine term structure models as tools for active bond portfolio management. We use multi-factor term structure models to produce forecasts for the future values of the state variables. Starting from the conditional moments of the state vector implied by the models, we introduce binomial approximations to come up with discrete scenarios for the future state variables. From the theoretical asset pricing relations we compute bond prices for various maturities at future dates and the associated returns. We use these returns as inputs for the portfolio optimization problem faced by an investor with a six month horizon who takes into account the possibility to rebalance after one quarter. Each quarter the optimizer selects the optimal portfolio, and the sequence of optimal portfolios is then evaluated in terms of financial properties. The results show that a financial based evaluation of term structure models may yield results conflicting with those obtained from a statistical evaluation.