Working Paper Series,
Stockholm School of Economics, China Economic Research Center

Abstract: Recent research shows that bond yields are influenced by monetary policy decisions. To learn how this works in an interest rate market that differs significantly from that of the U.S. and Europe, we model Chinese bond yields using the one-year deposit rate as a state variable. We also add the difference between the one-year interest rate and the one-year deposit rate as a factor. The model is developed in an affine framework and closed-form solutions are obtained. It is tested empirically and the results show that the new model characterizes the changing shape of the yield curve well. Incorporating the benchmark rate into the model thus helps us to match Chinese bond yields.

Keywords: China; deposit rate; bond yields; jump process; affine model

JEL-codes: E43; E44; E52; E58

33 pages, March 1, 2009

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