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Forecasting the Yield Curve Using Priors from No Arbitrage Affine Term Structure Models

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  • Andrea Carriero

    ()
    (Queen Mary, University of London)

Abstract

In this paper we propose a strategy for forecasting the term structure of interest rates which may produce significant gains in predictive accuracy. The key idea is to use the restrictions implied by Affine Term Structure Models (ATSM) on a vector autoregression (VAR) as prior information rather than imposing them dogmatically. This allows to account for possible model misspecification. We apply the method to a system of five US yields, and we find that the gains in predictive accuracy can be substantial. In particular, for horizons longer than 1-step ahead, our proposed method produces systematically better forecasts than those obtained by using a pure ATSM or an unrestricted VAR, and it also outperforms very competitive benchmarks as the Minnesota prior, the Diebold-Li (2006) model, and the random walk.

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Bibliographic Info

Paper provided by Queen Mary, University of London, School of Economics and Finance in its series Working Papers with number 612.

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Date of creation: Oct 2007
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Handle: RePEc:qmw:qmwecw:wp612

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Keywords: Bayesian methods; Forecasting; Term structure;

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References

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  1. Thomas Doan & Robert B. Litterman & Christopher A. Sims, 1986. "Forecasting and conditional projection using realistic prior distribution," Staff Report 93, Federal Reserve Bank of Minneapolis.
  2. Diebold, Francis X. & Piazzesi, Monica & Rudebusch, Glenn D., 2005. "Modeling bond yields in finance and macroeconomics," CFS Working Paper Series 2005/03, Center for Financial Studies (CFS).
  3. Diebold, Francis X. & Li, Canlin, 2006. "Forecasting the term structure of government bond yields," Journal of Econometrics, Elsevier, vol. 130(2), pages 337-364, February.
  4. Christopher A. Sims & Tao Zha, 1996. "Bayesian methods for dynamic multivariate models," Working Paper 96-13, Federal Reserve Bank of Atlanta.
  5. Ang, Andrew & Piazzesi, Monika & Wei, Min, 2006. "What does the yield curve tell us about GDP growth?," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 359-403.
  6. Darrell Duffie & Rui Kan, 1996. "A Yield-Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406.
  7. Del Negro, Marco & Schorfheide, Frank, 2005. "Monetary policy analysis with potentially misspecified models," Working Paper Series 0475, European Central Bank.
  8. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
  9. Marco Del Negro & Frank Schorfheide, 2005. "Policy Predictions if the Model Does Not Fit," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 434-443, 04/05.
  10. Marco Del Negro & Frank Schorfheide, 2002. "Priors from general equilibrium models for VARs," Working Paper 2002-14, Federal Reserve Bank of Atlanta.
  11. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  12. 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.
  13. Kadiyala, K Rao & Karlsson, Sune, 1997. "Numerical Methods for Estimation and Inference in Bayesian VAR-Models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 12(2), pages 99-132, March-Apr.
  14. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
  15. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  16. Ingram, Beth F. & Whiteman, Charles H., 1994. "Supplanting the 'Minnesota' prior: Forecasting macroeconomic time series using real business cycle model priors," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 497-510, December.
  17. 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.
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Cited by:
  1. Andrea Carriero & Raffaella Giacomini, 2011. "How useful are no-arbitrage restrictions for forecasting the term structure of interest rates?," Post-Print peer-00844809, HAL.
  2. Gregory R. Duffee, 2012. "Forecasting interest rates," Economics Working Paper Archive 599, The Johns Hopkins University,Department of Economics.
  3. Caio Almeida & Axel Simonsen & José Vicente, 2012. "Forecasting Bond Yields with Segmented Term Structure Models," Working Papers Series 288, Central Bank of Brazil, Research Department.
  4. David Jamieson Bolder & Yuliya Romanyuk, 2008. "Combining Canadian Interest-Rate Forecasts," Working Papers 08-34, Bank of Canada.

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