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Forecasting the yield curve in a data-rich environment: a no-arbitrage factor-augmented VAR approach

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  • Mönch, Emanuel

Abstract

This paper suggests a term structure model which parsimoniously exploits a broad macroeconomic information set. The model does not incorporate latent yield curve factors, but instead uses the common components of a large number of macroeconomic variables and the short rate as explanatory factors. Precisely, an affine term structure model with parameter restrictions implied by no-arbitrage is added to a Factor-Augmented Vector Autoregression (FAVAR). The model is found to strongly outperform different benchmark models in out-of-sample yield forecasts, reducing root mean squared forecast errors relative to the random walk up to 50% for short and around 20% for long maturities. JEL Classification: C13, C32, E43, E44, E52

Suggested Citation

  • Mönch, Emanuel, 2005. "Forecasting the yield curve in a data-rich environment: a no-arbitrage factor-augmented VAR approach," Working Paper Series 544, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2005544
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    More about this item

    Keywords

    Affine term structure models; dynamic factor models; FAVAR; yield curve;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • 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
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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