Affine Jump Term Structure Models: Expectation Puzzles and Conditional Volatility

Affine term structure models (ATSMs) ignore well-documented jumps in interest rates and fail to simultaneously capture the expectation puzzle and time-varying yield volatility. We develop affine jump term structure models (AJTSMs) with state variables following affine jump-diffusions and provide a comprehensive empirical analysis of three-factor AJTSMs using LIBOR and swap rates. We show that jumps (i) help to capture the conditional skewness and kurtosis of yields at short and long maturities and (ii) lead to more flexible specifications of (discrete-time) conditional yield variance and market prices of risks. Two sub-classes of three-factor AJTSMs simultaneously capture the expectation puzzle and time-varying yield volatility.