Yield Curve Factors, Term Structure Volatility, and Bond Risk Premia
AbstractWe introduce a Nelson-Siegel type interest rate term structure model with the underlying yield factors following autoregressive processes revealing time-varying stochastic volatility. The factor volatilities capture risk inherent to the term struc- ture and are associated with the time-varying uncertainty of the yield curve’s level, slope and curvature. Estimating the model based on U.S. government bond yields applying Markov chain Monte Carlo techniques we find that the yield factors and factor volatilities follow highly persistent processes. Using the extracted factors to explain one-year-ahead bond excess returns we observe that the slope and cur- vature yield factors contain the same explanatory power as the return-forecasting factor recently proposed by Cochrane and Piazzesi (2005). Moreover, we identify slope and curvature risk as important additional determinants of future excess returns. Finally, we illustrate that the yield and volatility factors are closely con- nected to variables reflecting macroeconomic activity, inflation, monetary policy and employment growth. It is shown that the extracted yield curve components have long-term prediction power for macroeconomic fundamentals.
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Bibliographic InfoPaper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2008-053.
Length: 47 pages
Date of creation: Jul 2008
Date of revision:
Term Structure Modelling; Yield Curve Risk; Stochastic Volatility; Factor Models; Macroeconomic Fundamentals;
Find related papers by JEL classification:
- C5 - Mathematical and Quantitative Methods - - Econometric Modeling
- E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
- G1 - Financial Economics - - General Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-08-14 (All new papers)
- NEP-ECM-2008-08-14 (Econometrics)
- NEP-FMK-2008-08-14 (Financial Markets)
- NEP-MAC-2008-08-14 (Macroeconomics)
- NEP-ORE-2008-08-14 (Operations Research)
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