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The dynamics of economics functions: modelling and forecasting the yield curve

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Clive G. Bowsher
Roland Meeks

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Abstract

The class of Functional Signal plus Noise (FSN) models is introduced that provides a new, general method for modelling and forecasting time series of economic functions. The underlying, continuous economic function (or "signal") is a natural cubic spline whose dynamic evolution is driven by a cointegrated vector autoregression for the ordinates (or "y-values") at the knots of the spline. The natural cubic spline provides flexible cross-sectional fit and results in a linear, state space model. This FSN model achieves dimension reduction, provides a coherent description of the observed yield curve and its dynamics as the cross-sectional dimension N becomes large, and can feasibly be estimated and used for forecasting when N is large. The integration and cointegration properties of the model are derived. The FSN models are then applied to forecasting 36-dimensional yield curves for US Treasury bonds at the one month ahead horizon. The method consistently outperforms the Diebold and Li (2006) and random walk forecasts on the basis of both mean square forecast error criteria and economically relevant loss functions derived from the realised profits of pairs trading algorithms. The analysis also highlights in a concrete setting the dangers of attempts to infer the relative economic value of model forecasts on the basis of their associated mean square forecast errors.

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Paper provided by Federal Reserve Bank of Dallas in its series Working Papers with number 0804.

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Date of creation: 2008
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Handle: RePEc:fip:feddwp:0804

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Keywords: Time-series analysis Forecasting Mathematical models Macroeconomics - Econometric models

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  5. Andrew Jeffrey & Oliver Linton & Thong Nguyen, 2006. "Flexible Term Structure Estimation: Which Method is Preferred?," Metrika, Springer, vol. 63(1), pages 99-122, February. [Downloadable!] (restricted)
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  7. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May. [Downloadable!] (restricted)
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  8. Brian Sack, 2000. "Using Treasury STRIPS to measure the yield curve," Finance and Economics Discussion Series 2000-42, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  9. Philippe C. Besse, 2000. "Autoregressive Forecasting of Some Functional Climatic Variations," Scandinavian Journal of Statistics, Danish Society for Theoretical Statistics, Finnish Statistical Society, Norwegian Statistical Association and Swedish Statistical Association, vol. 27(4), pages 673-687. [Downloadable!] (restricted)
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