A Diagnostic Tool for Yield Curve Models

Abstract

This paper explores an empirical methodology of investigating diffusion factor term structure models. This method is used to diagnose the validity of term structure models of given number of factors by investigating the uniqueness of stochastic discount factors implied by the models, or the equivalence of market price of risk across different bonds. Since we do not impose any parametric assumptions about dynamics of interest rates and market price of factor risk, this test constructs a direct inference on the consistency of diffusion factor models with bond data. We apply this methodology to a single factor diffusion model using daily data of Japan Government Bond (JGB) market over the period from January 2005 to December 2008.