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A Factor Model of the Term Structure of Interest Rates and Risk Premium Estimation for Latvia's Money Market

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  • Viktors Ajevskis
  • Kristine Vitola

Abstract

The paper presents the analysis of risk premium of the interest rate term structure for the Latvian money market. On the back of the approach used by F. Diebold, G. Rudebusch and B. Aruoba, it has been assumed that the coefficients of the Nelson–Siegel model are unobservable therefore the model of this research paper has been estimated using the Kalman filter. The risk premium behaviour has been obtained for interest rates of different maturities and forecasting horizons between May 2000 and July 2005. The results obtained indicate that the amount of the risk premium was significant and its volatility substantial between 2000 and 2002. In post-2002 period, its behaviour gradually stabilised and was marked by a downward trend after 2004.

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Bibliographic Info

Paper provided by Latvijas Banka in its series Working Papers with number 2006/01.

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Date of creation: 13 Feb 2006
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Handle: RePEc:ltv:wpaper:200601

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Related research

Keywords: term structure of interest rates; risk premium; the Nelson–Siegel model; the Kalman filter;

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References

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  1. Shiller, Robert J. & Huston McCulloch, J., 1990. "The term structure of interest rates," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 13, pages 627-722 Elsevier.
  2. Diebold, Francis X. & Li, Canlin, 2003. "Forecasting the term structure of government bond yields," CFS Working Paper Series 2004/09, Center for Financial Studies (CFS).
  3. Charles L. Evans & David A. Marshall, 1997. "Monetary policy and the term structure of nominal interest rates: evidence and theory," Working Paper Series, Macroeconomic Issues WP-97-10, Federal Reserve Bank of Chicago.
  4. Diebold, Francis X. & Rudebusch, Glenn D. & Borag[caron]an Aruoba, S., 2006. "The macroeconomy and the yield curve: a dynamic latent factor approach," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 309-338.
  5. Charles L. Evans & David Marshall, 2001. "Economic determinants of the nominal treasury yield curve," Working Paper Series WP-01-16, Federal Reserve Bank of Chicago.
  6. Pilegaard, Rasmus & Durré, Alain & Evjen, Snorre, 2003. "Estimating risk premia in money market rates," Working Paper Series 0221, European Central Bank.
  7. Francis X. Diebold & Monika Piazzesi & Glenn D. Rudebusch, 2005. "Modeling Bond Yields in Finance and Macroeconomics," PIER Working Paper Archive 05-008, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  8. Knez, Peter J & Litterman, Robert & Scheinkman, Jose Alexandre, 1994. " Explorations into Factors Explaining Money Market Returns," Journal of Finance, American Finance Association, vol. 49(5), pages 1861-82, December.
  9. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  10. Andrew Ang & Monika Piazzesi, 2001. "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables," NBER Working Papers 8363, National Bureau of Economic Research, Inc.
  11. Frankel, Jeffrey A & Lown, Cara S, 1994. "An Indicator of Future Inflation Extracted from the Steepness of the Interest Rate Yield Curve along Its Entire Length," The Quarterly Journal of Economics, MIT Press, vol. 109(2), pages 517-30, May.
  12. Barros Luís, Jorge & Cassola, Nuno, 2001. "A two-factor model of the German term structure of interest rates," Working Paper Series 0046, European Central Bank.
  13. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
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