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Two factors along the yield curve

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  • Frank F. Gong
  • Eli M. Remolona

Abstract

We estimate two-factor equilibrium models on different parts of the yield curve. In this exploration of the term structure of interest rates, we use two-factor affine yield models as our diagnostic tool. The exercise provides insights on how to reconcile the time-series dynamics of interest rates with the cross-sectional shapes of the term structure and on how movements in the yield curve are related to macroeconomic fundamentals. The evidence favors models in which one factor reverts over time to a time-varying mean. One such model seems adequate to explain three-month to two-year bond yields and another such model to explain two-year to ten-year yields. The models differ because mean reversion is much faster for yields near the short end of the curve than for yields near the long end. Near the short end, the implied factors capture mean reversion in inflation and the Federal Reserve's federal funds target rate. Near the long end, the factors also track the federal funds target but not inflation.

Suggested Citation

  • Frank F. Gong & Eli M. Remolona, 1996. "Two factors along the yield curve," Research Paper 9613, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednrp:9613
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    Cited by:

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    2. D H Kim, 2005. "Nonlinearity in the Term Structure," Centre for Growth and Business Cycle Research Discussion Paper Series 51, Economics, The University of Manchester.
    3. Somvang PHIMMAVONG & Ian FERGUSON & Barbara OZARSKA, 2010. "Economy-Wide Impact of Forest Plantation Development in Laos Using a Dynamic General Equilibrium Approach," EcoMod2010 259600131, EcoMod.
    4. Michael J. Fleming & Eli M Remolona, 1999. "The term structure of announcement effects," BIS Working Papers 71, Bank for International Settlements.
    5. Peter Smith & Michael Wickens, 2002. "Asset Pricing with Observable Stochastic Discount Factors," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 397-446, July.
    6. Dong Heon Kim, 2004. "Nonlinearity in the Term Structure," Econometric Society 2004 Far Eastern Meetings 440, Econometric Society.
    7. R.C. Stapleton & Marti G. Subrahmanyam, 1999. "The Term Structure of Interest Rate-Futures Prices," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-045, New York University, Leonard N. Stern School of Business-.
    8. D H Kim, 2004. "Nonlinearity in the Term Structure," Economics Discussion Paper Series 0401, Economics, The University of Manchester.
    9. Barros Luís, Jorge & Cassola, Nuno, 2001. "A two-factor model of the German term structure of interest rates," Working Paper Series 0046, European Central Bank.
    10. Peter Spencer, 2004. "Affine Macroeconomic Models of the Term Structure of Interest Rates: The US Treasury Market 1961-99," Discussion Papers 04/16, Department of Economics, University of York, revised Jan 2006.
    11. Ben Fung & Scott Mitnick & Eli Remolona, 1999. "Uncovering Inflation Expectations and Risk Premiums From Internationally Integrated Financial Markets," Staff Working Papers 99-6, Bank of Canada.
    12. Fendel, Ralf, 2004. "Towards a Joint Characterization of Monetary Policy and the Dynamics of the Term Structure of Interest Rates," Discussion Paper Series 1: Economic Studies 2004,24, Deutsche Bundesbank.
    13. Lekkos, Ilias, 2007. "Modelling multiple term structures of defaultable bonds with common and idiosyncratic state variables," Journal of Empirical Finance, Elsevier, vol. 14(5), pages 783-817, December.

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