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Term structure modelling with observable state variables

  • Huse, Cristian

This paper proposes and implements a parsimonious three-factor model of the term structure whose dynamics is driven uniquely by observable state variables. This approach allows comparing alternative views on the way state variables – macroeconomic variables, in particular – influence the yield curve dynamics, avoids curse of dimensionality problems, and provides more reliable inference by using both the cross-sectional and the time series dimension of the data. I simulate the small-sample properties of the procedure and conduct in- and out-of-sample studies using a comprehensive set of US data. I show that even a parsimonious model where the level, slope and curvature factors of the term structure are driven by, respectively, inflation, monetary policy and economic activity consistently outperforms the (latent-variable) benchmark model in an out-of-sample study.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 35 (2011)
Issue (Month): 12 ()
Pages: 3240-3252

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Handle: RePEc:eee:jbfina:v:35:y:2011:i:12:p:3240-3252
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