The Role of No-Arbitrage Restriction in Term Structure Model in the Context of an Emerging Market

The precise estimation and forecasting of the term structure of interest rate is of vital importance in the context of macroeconomics and finance as the yield curve is considered the fundamental conduit of the monetary policy signal to the real sector. This study examines the extent to which the so called Dynamic Nelson-Siegel model (DNS) and its extended version that impose the no-arbitrage restriction in the standard DNS (AFNS) can fit the term structure of interest rates and forecast its future path in the context of an emerging economy. Both models are illustrated in the state-space framework and empirically compared in terms of in-sample fit and out-of-sample forecast accuracy. For the in-sample fit, both models fit the curve remarkably well even in emerging markets. However, the AFNS model fits the curve slightly better than the DNS model. Regarding the out-of-sample forecasts, the results indicate that the affine based extended model comes with more precise forecasts than the DNS for medium and long term maturities, while the standard DNS outperforms the AFNS at the short end of the yield curve for all three forecast horizons, i.e., 1-, 6- and 12-months. Overall, the results show that there is no single forecast model that dominates its competitors.