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Abstract. That information surprises result in discontinuous interest rates is no surprise to participants in the bond markets. We develop a class of Poisson-Gaussian models of the Fed Funds rate to capture surprise effects, and show that these models offer a good statistical description of short rate behavior, and are useful in understanding many empirical phenomena. Estimators are used based on analytical derivations of the characteristic functions and moments of jump-diffusion stochastic processes for a range of jump distributions, and are extended to discrete-time models. Jump (Poisson) processes capture empirical features of the data which would not be captured by Gaussian models, and there is strong evidence that existing models would be well-enhanced by jump and ARCH-type processes. The analytical and empirical methods in the paper support many applications, such as testing for Fed intervention effects, which are shown to be an important source of surprise jumps in interest rates. The jump model is shown to mitigate the non-linearity of interest rate drifts, so prevalent in pure-diffusion models. Day-of-week effects are modelled explicitly, and the jump model provides evidence of bond market overreaction, rejecting the martingale hypothesis for interest rates. Jump models mixed with Markov switching processes predicate that conditioning on regime is important in determining short rate behavior.

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This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events (λ Q), but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single-factor model with λ Q following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in λ Q are found to be economically significant and co-vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy. THE BURGEONING MARKET FOR SOVEREIGN CREDIT DEFAULT SWAPS (CDS) contracts offers a nearly unique window for viewing investors ’ risk-neutral probabilities of major credit events impinging on sovereign issuers, and their risk-neutral losses of principal in the event of a restructuring or repudiation of external debts. In contrast to many “emerging market ” sovereign bonds, sovereign CDS

Abstract: We estimate a model that summarizes the yield curve using latent factors (specifically, level, slope, and curvature) and also includes observable macroeconomic variables (specifically, real activity, inflation, and the monetary policy instrument). Our goal is to provide a characterization of the dynamic interactions between the macroeconomy and the yield curve. We find strong evidence of the effects of macro variables on future movements in the yield curve and evidence for a reverse influence as well. We also relate our results to the expectations hypothesis.

This paper develops an arbitrage-free time-series model of yields in continuous time that incorporates central bank policy. Policy-related events, such as FOMC meetings and releases of macroeconomic news the Fed cares about, are modeled as jumps. The model introduces a class of linear-quadratic jump-diffusions as state variables, which allows for a wide variety of jump types but still leads to tractable solutions for bond prices. I estimate a version of this model with U.S. interest rates, the Federal Reserve’s target rate, and key macroeconomic aggregates. The estimated model improves bond pricing, especially at short maturities. The “snake-shape ” of the volatility curve is linked to monetary policy inertia. A new monetary policy shock series is obtained by assuming that the Fed reacts to information available right before the FOMC meeting. According to the estimated policy rule, the Fed is mainly reacting to information contained in the yield-curve. Surprises in analyst forecasts turn out to be merely temporary components of macro variables, so that the “hump-shaped” yield response to these surprises is not consistent with a Taylor-type policy rule.

This paper is a critical survey of models designed for pricing fixed income securities and their associated term structures of market yields. Our primary focus is on the interplay between the theoretical specification of dynamic term structure models and their empirical fit to historical changes in the shapes of yield curves. We begin by overviewing the dynamic term structure models that have been fit to treasury or swap yield curves and in which the risk factors follow diffusions, jump-diffusion, or have “switching regimes. ” Then the goodness-of-fits of these models are assessed relative to their abilities to: (i) match linear projections of changes in yields onto the slope of the yield curve; (ii) match the persistence of conditional volatilities, and the shapes of term structures of unconditional volatilities, of yields; and (iii) to reliably price caps, swaptions, and other fixed-income derivatives. For the case of defaultable securities we explore the relative fits to historical yield spreads. 1

We identify and characterize a class of term structure models where bond yields are quadratic functions of the state vector. We label this class the quadratic class and aim to lay a solid theoretical foundation for its future empirical application. We consider asset pricing in general and derivative pricing in particular under the quadratic class. We provide two general transform methods in pricing a wide variety of fixed income derivatives in closed or semi-closed form. We further illustrate how the quadratic model and the transform methods can be applied to more general settings. # Swiss Banking Institute, University of Zurich, Plattenstr. 14, 8032 Zurich, Switzerland and Graduate School of Business, Fordham University, 113 West 60th Street, New York, NY 10023, USA, respectively. We thank Marco Avellaneda, David Backus, Peter Carr, Pierre Collin, Silverio Foresi, Michael Gallmeyer, Richard Green, Massoud Heidari, Burton Hollifield, Regis Van Steenkiste, Chris Telmer, Stanley Zin, and, in particular, Jonathan M. Karpo# (the editor) as well as two anonymous referees for helpful comments. I.

Recent advances in the theory of credit risk allow the use of standard term structure machinery for default risk modeling and estimation. The empirical literature in this area often interprets the drift adjustments of the default intensity’s diffusion state variables as the only default risk premium. We show that this interpretation implies a restriction on the form of possible default risk premia, which can be justified through exact and approximate notions of “diversifiable default risk.” The equivalence between the empirical and martingale default intensities that follows from diversifiable default risk greatly facilitates the pricing and management of credit risk. We emphasize that this is not an equivalence in distribution, and illustrate its importance using credit spread dynamics estimated in Duffee (1999). We also argue that the assumption of diversifiability is implicitly used in certain existing models of mortgage-backed securities.