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The Central Tendency: A Second Factor in Bond Yields

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  • Pierluigi Balduzzi
  • Sanjiv Ranjan Das
  • Silverio Foresi

Abstract

We assume that the instantaneous riskless rate reverts towards a central tendency which in turn, is changing stochastically over time. As a result, current short-term rates are not" sufficient to predict future short-term rates movements, as would be the case if the central" tendency was constant. However, since longer-maturity bond prices incorporate information" about the central tendency, longer-maturity bond yields can be used to predict future short-term" rate movements. We develop a two-factor model of the term-structure which implies that a" linear combination of any two rates can be used as a proxy for the central tendency. Based on" this central-tendency proxy, we estimate a model of the one-month rate which performs better" than models which assume the central tendency to be constant.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6325.

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Date of creation: Dec 1997
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Publication status: published as Review of Economics and Statistics, Vol. 80, no. 1 (February 1998): 62-72.
Handle: RePEc:nbr:nberwo:6325

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  1. Pearson, Neil D & Sun, Tong-Sheng, 1994. " Exploiting the Conditional Density in Estimating the Term Structure: An Application to the Cox, Ingersoll, and Ross Model," Journal of Finance, American Finance Association, American Finance Association, vol. 49(4), pages 1279-1304, September.
  2. Fama, Eugene F., 1984. "The information in the term structure," Journal of Financial Economics, Elsevier, Elsevier, vol. 13(4), pages 509-528, December.
  3. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, American Finance Association, vol. 47(3), pages 1209-27, July.
  4. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 385-407, March.
  5. Campbell, John & Shiller, Robert, 1987. "Cointegration and Tests of Present Value Models," Scholarly Articles 3122490, Harvard University Department of Economics.
  6. N. Gregory Mankiw, 1986. "The Term Structure of Interest Rates Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 17(1), pages 61-110.
  7. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, American Economic Association, vol. 77(4), pages 680-92, September.
  8. Longstaff, Francis A & Schwartz, Eduardo S, 1992. " Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model," Journal of Finance, American Finance Association, American Finance Association, vol. 47(4), pages 1259-82, September.
  9. Brennan, Michael J. & Schwartz, Eduardo S., 1979. "A continuous time approach to the pricing of bonds," Journal of Banking & Finance, Elsevier, Elsevier, vol. 3(2), pages 133-155, July.
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