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The Central Tendency: A Second Factor In Bond Yields

  • Pierluigi Balduzzi
  • Sanjiv Ranjan Das
  • Silverio Foresi

We assume that the instantaneous riskless rate reverts toward 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 rate movements, as it would be the case if the central tendency were 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 that performs better than models which assume the central tendency to be constant. © 1998 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology

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Article provided by MIT Press in its journal The Review of Economics and Statistics.

Volume (Year): 80 (1998)
Issue (Month): 1 (February)
Pages: 62-72

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Handle: RePEc:tpr:restat:v:80:y:1998:i:1:p:62-72
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  1. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," Cowles Foundation Discussion Papers 785, Cowles Foundation for Research in Economics, Yale University.
  2. Fama, Eugene F., 1984. "The information in the term structure," Journal of Financial Economics, Elsevier, vol. 13(4), pages 509-528, December.
  3. Brennan, Michael J. & Schwartz, Eduardo S., 1979. "A continuous time approach to the pricing of bonds," Journal of Banking & Finance, Elsevier, vol. 3(2), pages 133-155, 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, vol. 53(2), pages 385-407, March.
  5. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
  6. 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, vol. 49(4), pages 1279-1304, September.
  7. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September.
  8. 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.
  9. 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, vol. 47(4), pages 1259-82, September.
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