Testing affine term structure models in case of transaction costs

• Published in: Journal of econometrics Vol. 126; no. 1; pp. 201 - 232
• Main Authors: Driessen, Joost, Melenberg, Bertrand, Nijman, Theo
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.05.2005; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Econometrics
• Subjects: Applications; Costs; Econometrics; Economic models; Economic performance; Exact sciences and technology; Insurance, economics, finance; Interest rate models; Interest rates; Market frictions; Mathematics; Model misspecification; Model testing; Probability and statistics; Sciences and techniques of general use; Statistics; Studies; Term structure; Transaction costs; Transactional analysis; G12; Interest rate models; Market frictions; Model misspecification; E43; Transaction costs; Statistical test; Data analysis; Transaction cost; Factor model; Error estimation; Interest rate; Misspecification model; Statistical estimation; Market friction; Econometrics; Economic data
• ISSN: 0304-4076; 1872-6895
• DOI: 10.1016/j.jeconom.2004.04.014

We empirically analyze the impact of transaction costs on the performance of essentially affine interest rate models. We test the implied Euler restrictions and calculate the specification error bound of Hansen and Jagannathan to measure model misspecification. Using both short-maturity and long-maturity bond return data we find, under the assumption of frictionless markets, strong evidence of misspecification of affine yield models with up to three factors. Next, we incorporate transaction costs in our tests. The results show that the evidence of misspecification of essentially affine yield models disappears in case of monthly holding periods at market size transaction costs.