Nonlinearity in the Term Structure

This paper uses the flexible approach of Hamilton (2001) to investigate the nature of nonlinearities in the term structure. The paper reports clear evidence of nonlinearity, in contrast to the affine term structure model and consistent with recent claims in the literature. We find that there is a threshold effect of volatility on the interest rate but this effect does not capture the entire nature of the nonlinearity. The quadratic term structure model recently proposed performs better for capturing the nonlinearity than the threshold model but the former model seems to miss some aspect of nonlinearity for short-term rates. However, our flexible nonlinear model which incorporates the threshold effect and the convexity of volatility into the quadratic model, generally performs well for all interest rates. The paper suggests that this model is a promising representation of nonlinearities and out-of-sample forecasts support the claim of nonlinearities