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The Role of No-Arbitrage on Forecasting: Lessons from a Parametric Term Structure Model

  • Almeida, Caio Ibsen Rodrigues de
  • Vicente, José Valentim M.

Parametric term structure models have been successfully applied to numerous problems in fixed income markets, including pricing, hedging, managing risk, as well as to the study of monetary policy implications. In turn, dynamic term structure models, equipped with stronger economic structure, have been mainly adopted to price derivatives and explain empirical stylized facts. In this paper, we combine flavors of those two classes of models to test whether no-arbitrage affects forecasting. We construct cross-sectional (allowing arbitrages) and arbitrage-free versions of a parametric polynomial model to analyze how well they predict out-of-sample interest rates. Based on US Treasury yield data, we find that no-arbitrage restrictions significantly improve forecasts. Arbitrage-free versions achieve overall smaller biases and root mean square errors for most maturities and forecasting horizons. Furthermore, a decomposition of forecasts into forward-rates and holding return premia indicates that the superior performance of no-arbitrage versions is due to a better identification of bond risk premium.

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Paper provided by FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil) in its series Economics Working Papers (Ensaios Economicos da EPGE) with number 657.

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Date of creation: 01 Oct 2007
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Handle: RePEc:fgv:epgewp:657
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  13. Jens H. E. Christensen & Francis X. Diebold & Glenn D. Rudebusch, 2007. "The Affine Arbitrage-Free Class of Nelson-Siegel Term Structure Models," PIER Working Paper Archive 07-029, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
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  16. Caio Ibsen Rodrigues De Almeida, 2005. "Affine Processes, Arbitrage-Free Term Structures Of Legendre Polynomials, And Option Pricing," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(02), pages 161-184.
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