Empirical Implementation of a Term Structure Model with Stochastic Volatility

We provide the empirical implementation of the term-structure model developed in Fornari and Mele (1998). This model is based on a continuous time economy exhibiting equilibrium dynamics to which most asymmetric ARCH models converge in distribution as the sample frequency gets in nite. We obtain estimates of the model’s parameters that are based on an indirect inference scheme in which such convergence results are used to exploit ARCH as auxiliary models. With such estimates at hand, we implement a Crank-Nicholson type scheme and numerically solve for the equilibrium term structure predicted by our theoretical model. We nd that shocks to the short term interest rate co-move positively with shocks to volatility and that the whole term-structure of interest rates sharpens as volatility increases.