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Forecasting with the term structure: The role of no-arbitrage restrictions

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  • Greg Duffee

Abstract

No-arbitrage term structure models impose cross-sectional restrictions among yields and can be used to impose dynamic restrictions on risk compensation. This paper evaluates the importance of these restrictions when using the term structure to forecast future bond yields. It concludes that no cross-sectional restrictions are helpful, because cross-sectional properties of yields are easy to infer with high precision. Dynamic restrictions are useful, but can be imposed without relying on the no-arbitrage structure. In practice, the most important dynamic restriction is that the first principal component of Treasury yields follows a random walk. A simple model built around this assumption produces out-of-sample forecasts that are more accurate than those of a variety of alternative dynamic models.

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Bibliographic Info

Paper provided by The Johns Hopkins University,Department of Economics in its series Economics Working Paper Archive with number 576.

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Date of creation: Jan 2011
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Handle: RePEc:jhu:papers:576

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  1. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," NBER Working Papers 4676, National Bureau of Economic Research, Inc.
  2. Francis X. Diebold & Canlin Li, 2003. "Forecasting the Term Structure of Government Bond Yields," NBER Working Papers 10048, National Bureau of Economic Research, Inc.
  3. Duffee, Gregory R, 1996. " Idiosyncratic Variation of Treasury Bill Yields," Journal of Finance, American Finance Association, American Finance Association, vol. 51(2), pages 527-51, June.
  4. Jens H. E. Christensen & Francis X. Diebold & Glenn D. Rudebusch, 2007. "The Affine Arbitrage-Free Class of Nelson-Siegel Term Structure Models," PIER Working Paper Archive 07-029, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  5. Pagan, A.R. & Hall, A.D. & Martin, V., 1995. "Modelling the Term Structure," Papers, Australian National University - Department of Economics 284, Australian National University - Department of Economics.
  6. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, American Finance Association, vol. 57(1), pages 405-443, 02.
  7. Greg Duffee, 2011. "Information in (and not in) the term structure," Economics Working Paper Archive, The Johns Hopkins University,Department of Economics 577, The Johns Hopkins University,Department of Economics.
  8. Greenwood, Robin & Vayanos, Dimitri, 2008. "Bond Supply and Excess Bond Returns," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6694, C.E.P.R. Discussion Papers.
  9. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1996. "On Biases in Tests of the Expecations Hypothesis of the Term Structure Of Interest Rates," NBER Technical Working Papers 0191, National Bureau of Economic Research, Inc.
  10. Greg Duffee, 2010. "Sharpe ratios in term structure models," Economics Working Paper Archive, The Johns Hopkins University,Department of Economics 575, The Johns Hopkins University,Department of Economics.
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Cited by:
  1. Greg Duffee, 2011. "Information in (and not in) the term structure," Economics Working Paper Archive, The Johns Hopkins University,Department of Economics 577, The Johns Hopkins University,Department of Economics.
  2. James D. Hamilton & Jing Cynthia Wu, 2011. "The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment," NBER Working Papers 16956, National Bureau of Economic Research, Inc.
  3. James D. Hamilton & Jing Cynthia Wu, 2012. "Identification and Estimation of Gaussian Affine Term Structure Models," NBER Working Papers 17772, National Bureau of Economic Research, Inc.
  4. A. Carriero & G. Kapetanios & M. Marcellino, 2010. "Forecasting Government Bond Yields with Large Bayesian VARs," Economics Working Papers, European University Institute ECO2010/17, European University Institute.
  5. Hamilton, James D. & Wu, Jing Cynthia, 2014. "Testable implications of affine term structure models," Journal of Econometrics, Elsevier, Elsevier, vol. 178(P2), pages 231-242.
  6. Siem Jan Koopman & Michel van der Wel, 2011. "Forecasting the U.S. Term Structure of Interest Rates using a Macroeconomic Smooth Dynamic Factor Model," Tinbergen Institute Discussion Papers 11-063/4, Tinbergen Institute.
  7. Carriero, Andrea & Kapetanios, George & Marcellino, Massimiliano, 2012. "Forecasting government bond yields with large Bayesian vector autoregressions," Journal of Banking & Finance, Elsevier, vol. 36(7), pages 2026-2047.
  8. Joslin, Scott & Le, Anh & Singleton, Kenneth J., 2013. "Why Gaussian macro-finance term structure models are (nearly) unconstrained factor-VARs," Journal of Financial Economics, Elsevier, Elsevier, vol. 109(3), pages 604-622.

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