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Long-run priors for term structure models

Author

Listed:
  • Meldrum, Andrew

    (Bank of England)

  • Roberts-Sklar, Matt

    (Bank of England)

Abstract

Dynamic no-arbitrage term structure models are popular tools for decomposing bond yields into expectations of future short-term interest rates and term premia. But there is insufficient information in the time series of observed yields to estimate the unconditional mean of yields in maximally flexible models. This can result in implausibly low estimates of long-term expected future short-term interest rates, as well as considerable uncertainty around those estimates. This paper proposes a tractable Bayesian approach for incorporating prior information about the unconditional means of yields. We apply it to UK data and find that with reasonable priors it results in more plausible estimates of the long-run average of yields, lower estimates of term premia in long-term bonds and substantially reduced uncertainty around these decompositions in both affine and shadow rate term structure models.

Suggested Citation

  • Meldrum, Andrew & Roberts-Sklar, Matt, 2015. "Long-run priors for term structure models," Bank of England working papers 575, Bank of England.
  • Handle: RePEc:boe:boeewp:0575
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    References listed on IDEAS

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    Cited by:

    1. Lloyd, Simon P., 2020. "Estimating nominal interest rate expectations: Overnight indexed swaps and the term structure," Journal of Banking & Finance, Elsevier, vol. 119(C).

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    More about this item

    Keywords

    Affine term structure model; shadow rate term structure model; Gibbs sampler;
    All these keywords.

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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