An Admissible Affine Model for Joint Term Structure Dynamics of Interest Rates

We present and estimate a parsimonious continuous-time multi-factor affine term structure model for the joint term structure dynamics of interest rates across countries. We extend the standard affine models by focusing on joint markets and by incorporating the exchange rate dynamics in the estimation procedure. Estimation on UK-US term structure data is done by means of a Kalman filter algorithm and quasi maximum likelihood inference. We find that our particular three factor model is rather successful in fitting bond correlations, both within and between national bond markets. Moreover, the model sheds light on two of the most persistent puzzles in empirical international finance, i.e. the forward premium puzzle and the (bond portfolio) home bias puzzle. Our model implies that the empirical forward premium puzzle is due to (i) the existence of time varying risk premia and (ii) the small sample properties of the estimator caused by the strong inertia in (some of) the factors (in line with Baillie and Bollerslev (2000)). With respect to the home bias puzzle, the model allows to test for international diversification gains in unhedged bond return portfolios, conditional on information that is present in the joint term structure of both countries. We find that exchange rate risk is sufficiently priced such that the inclusion of foreign bonds allows for an improved time-dependent risk-return trade off from the perspective of a UK investor.