Testing term structure estimation methods
This paper tests and compares five distinct methods for estimating the term structure. The Unsmoothed Fama-Bliss method is an iterative method by which the discount rate function is built up by computing the forward rate necessary to price successively longer maturity bonds. The Smoothed Fama-Bliss "smooths out" these discount rates by fitting an approximating function to the "unsmoothed" rates. The McCulloch method fits a cubic spline to the discount function using an implicit smoothness penalty, while the Fisher-Nychka-Zervos method fits a cubic spline to the forward rate function and makes the smoothness penalty explicit. Lastly, the Extended Nelson-Siegel method, introduced in this paper, fits an exponential approximation of the discount rate function directly to bond prices. ; The tests demonstrate the dangers of in-sample goodness-of-fit as the sole criterion for judging term structure estimation methods. A series of residual analysis tests are introduced to detect misspecification of the underlying pricing equation relating the term structure to bond prices. These tests establish the presence of unspecified, but nonetheless systematic, omitted factors in the prices of long maturity notes and bonds. ; Comparisons of the five term structure estimation methods using these parametric and non-parametric tests finds that the Unsmoothed Fama-Bliss does best overall. Differences with some alternatives may not be economically significant given the much larger number of parameters this method estimates. Users seeking a parsimonious representation of the term structure should consider either the Smoothed Fama-Bliss or the Extended Nelson-Siegel methods. One method was found to be unacceptable. The Fisher-Nychka-Zervos cubic spline method performs poorly relative to the alternatives, both in- and out-of-sample. Furthermore, it systematically misprices short maturity issues and suffers from instability in the estimated term structure.
|Date of creation:||1996|
|Publication status:||Published in Advances in Futures and Options Research, 1997|
|Contact details of provider:|| Postal: 1000 Peachtree St., N.E., Atlanta, Georgia 30309|
Web page: http://www.frbatlanta.org/
More information through EDIRC
|Order Information:|| Email: |
When requesting a correction, please mention this item's handle: RePEc:fip:fedawp:96-12. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Elaine Clokey)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.