Interest Rate Volatility and
2014
An important aspect of any dynamic model of volatility is the requirement that volatility be positive. We show that for no-arbitrage ane term structure models, this admissibility constraint gives rise to a tension in simultaneous tting of the physical and risk-neutral yields forecasts. In resolving this tension, the risk-neutral dynamics is typically given more priority, thanks to its superior identication. Consequently, the time-series dynamics are derived partly from the cross-sectional information; thus, time-series yields forecasts are strongly inuenced by the no-arbitrage constraints. We nd that this feature in turn underlies the well-known failure of these models with stochastic volatility to explain the deviations from the Expectations Hypothesis observed in the data.
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