An International Examination of Affine Term Structure Models and the Expectations Hypothesis

We examine the yield curve behavior and the relative performance of affine term structure models using government bond yield data from Canada, Germany, Japan, UK, and US. We find strong predictability of forward rates for excess bond returns and reject the expectations hypothesis across all five countries. A three-factor model is sufficient to capture movements in the yield curve of Canada, Japan, UK, and US, but may not be enough for Germany. An exhaustive comparison among affine term structure models with no more than three factors reveals that the three-factor essential affine model (A1(3)E) with only one factor affecting the volatility of the short rate but with all three factors affecting the price of risk performs best in all five countries. Simulations provide inconclusive evidence on whether this best affine model can successfully generate the rich yield curve behavior observed in the data. ∗We thank Andy Abel, Michael Brennan, Qiang Dai, Chris Geczy, Rich Kihlstrom, and Allan White for helpful discussions. Xia acknowledges financial support from the Weiss Center for International Financial Research and the Rodney L. White Center for Financial Research at the Wharton School. †Ph.D. candidate, Finance Department, The Wharton School, University of Pennsylvania, Philadelphia, PA 19104-6367. Email: [email protected]. ‡Assistant Professor, Finance Department, The Wharton School, University of Pennsylvania; 2300 Steinberg Hall-Dietrich Hall; Philadelphia, PA 19104-6367. Phone: (215) 898-3004. Fax: (215) 898-6200. E-mail: [email protected].