Testing Linearity in Term Structures

This version: 13/07/09 Recent empirical studies suggests that affine models, a popular framework to analyse term structures of interest rates, are misspecified. This evidence is mainly based on time series properties of the data. This article re-examines this controversy, by investigating both cross-sectional and dynamic properties of affine models. To do so, it applies robust non-parametric techniques to two different sets of financial data, which contain information on the UK and US yield curve. The analysis shows the strong non-linearity in the relationship of yields to the US and UK short rate. The non-linear pattern is concave in the state variable, and increasing with respect to the maturity, for both countries. Linear and non-linear specifications are then compared by means of a formal statistical criterion, the Generalised Likelihood-Ratio test statistics, which confirms evidence against the linear specification. KEY WORDS: interest rates; term structure; affine models; non-linearity; non-parametric regression