“Variance Dynamics in Term Structure Models”
by Çisil Sarısoy
Kellogg School of Management, Ph.D in Finance
I design a novel specification test for diagnosing the adequacy of affine term structure models to describe the observed yield variance dynamics, and derive the associated limit theory necessary for carrying out the test. The test statistic utilizes model–free estimators of instantaneous variances based on intraday data as well as model-free prices of variance swaps. Hence, it enables a direct testing of variance dynamics, independent of any specific modeling assumptions. I implement the test statistic in Eurodollar futures and options markets and find that affine term structure models cannot accommodate the yield variance dynamics observed in the data, especially during the crisis period of 2008–2010. However, a logarithmic affine specification of variances provides a remarkably improved fit.