A term structure model of interest rates with quadratic volatility

This study proposes a no-arbitrage term structure model that can capture the volatility of interest rates without sacrificing the goodness-of-fit to the cross-section and predictive ability about the level of interest rates. The key feature of the model is the covariance matrix of changes in factors, which is specified as quadratic functions of factors. The quadratic specification can capture intense volatility even with spanned factors, which is not the case for the affine specification. Furthermore, since the quadratic specification guarantees the positive definiteness of the covariance matrix without restricting the sign of factors, it allows for a flexible specification of the physical drift as does the Gaussian term structure model, contributing also to accurate level prediction.