An empirical analysis of unspanned risk for the U.S. yield curve
DOI:
https://doi.org/10.17533/udea.le.n85a01Keywords:
liquidity risk, inflation-indexed bond market, affine term structure, unspanned factors, predictabilityAbstract
In this paper, I formally test for the unspanning properties of liquidity premium risk in the context of a joint Gaussian affine term structure model for zero-coupon U.S. Treasury and TIPS bonds. In the model, the liquidity factor is regarded as an additional factor that does not span the yield curve, but improves the forecast of bond risk premia. I present empirical evidence suggesting that liquidity premium indeed helps to forecast U.S. bond risk premia in spite of not being linearly spanned by the information in the joint yield curve. In addition, I show that the liquidity factor does not affect the dynamics of bonds under the pricing measure, but does affect them under the historical measure. Further, variation in the TIPS liquidity premium predicts the future evolution of the traditional yield curve factors.
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