Yield-Factor Volatility Models

The term structure of interest rates is often summarized using a handful of yield factors that capture shifts in the shape of the yield curve. In this paper, we develop a comprehensive model for volatility dynamics in the level, slope, and curvature factors that simultaneously includes level and GARCH effects along with regime shifts. We show that the level of the short-rate is useful in modeling the volatility of the three yield factors and that there is significant GARCH effects present even after including a level effect. We also study the effect of interest rate volatility on the level of the yield factors and report evidence that is consistent with a ”flight-to-cash”. Furthermore, we show that allowing for regime shifts in the factor volatilities dramatically improves the model’s fit and strengthens the level effect. Finally, we discuss how the dynamics of yield factors we identify could potentially be used to discriminate between alternative term structure models. JEL Code: E43, C32, C51 ∗Faculty of Business Administration, Simon Fraser University, Canada. We thank Peter Klein, Andrey Pavlov, and seminar participants at Simon Fraser University for their comments. We would also like to thank Robert Bliss for providing us with data and his programs for constructing yield curves. We gratefully acknowledge financial support from the Social Sciences and Research Council of Canada. Emails: [email protected]; [email protected].