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Modeling the time-varying dynamic term structure of interest rates

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  • Choi, Ahjin
  • Kang, Kyu Ho

Abstract

We propose a new dynamic Nelson–Siegel yield curve model in which two time-varying factor-specific decay parameters govern the slope and curvature factor loadings, and the factor shock variance–covariance (SV) follows a stochastic inverse Wishart process. The proposed model is compared with simpler specifications in terms of statistical and economic criteria to demonstrate the importance of jointly incorporating time-varying factor loadings and SV. We examine the out-of-sample yield curve density forecasting performance for statistical evaluation. The utility gain from the bond portfolio optimization of a Bayesian risk-averse investor measures the model’s economic value. Our out-of-sample experiment using United States monthly yield curve data indicates that the time-varying factor loadings and SV accommodate gradual structural changes in the yield curve dynamics around an unconventional monetary policy period, thereby improving the predictive accuracy and utility gain.

Suggested Citation

  • Choi, Ahjin & Kang, Kyu Ho, 2023. "Modeling the time-varying dynamic term structure of interest rates," Journal of Banking & Finance, Elsevier, vol. 153(C).
    • Handle: RePEc:eee:jbfina:v:153:y:2023:i:c:s0378426623001206
    DOI: 10.1016/j.jbankfin.2023.106908
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    More about this item

    Keywords

    Out-of-sample density forecasting; Bond portfolio choice; Posterior predictive likelihood; Certainty equivalent return;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications

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