Time-varying yield curve dynamics and interactions for Turkish sovereign bonds

Abstract

Sovereign bond yields are one of the fundamental indicators that investors use as benchmark for other interest rates and draw inferences regarding future situation of the economy. Early interpretation of the relationship between term to maturity and bond yields depended on the expectations hypothesis which proposes that long-term interest rates reflect expected future short-term interest rates except a possible constant liquidity preference premium. However, researchers documented that holding returns on investing long-term bonds over short-term bonds have a time varying forecastable component suggesting that investors demand a premium as compensation for interest rate risk they bear. A growing body of research aims to understand time-variation in term premium. This study contributes to the topic by identifying determinants of term premium in Turkish treasury yields. First part of the thesis employs a Nelson Siegel class model to generate continuous yield estimates directly from the quotes in bond market. In the second part, the resulting yield curves are used as input to construct a three-factor ACM model which decomposes observed yields into risk-neutral and term premium components. Regression analyses suggest that a combination of measures representing market risk, liquidity risk, credit risk, and behavioral factors can explain the majority of the variation in term premia. Explanation power of the credit risk measure is found to increase while those of liquidity, volatility, and behavioral factors diminish with the maturity horizon.