Abstract
It has been indicated by Litterman and Scheinkman (1991) that the term structure of interest rates is reliably modeled by an affine three factor model attained by principal component analysis. Such a model is inconsistent with no arbitrage: it allows portfolios with zero instantaneous variance to have returns that are different from the risk free rate. Such an excess return is called convenience yield. We derive an explicit formula for the convenience yield, use historical data of US treasuries to estimate its parameters, and find that the convenience yield predicted by our formula is surprisingly large. We then compare the predicted convenience yield to the one obtained in practice and find an excellent fit between the two.
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