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A three-factor econometric model of the U.S. term structure

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  • Frank F. Gong
  • Eli M. Remolona

Abstract

We estimate and test a model of the U.S. term structure that fits both the time series of interest rates and the cross-sectional shapes of the yield and volatility curves. In the model, three unobserved factors drive a stochastic discount process that prices assets so as to rule out arbitrage opportunities. The resulting bond yields are conveniently affine in the factors. We use monthly zero-coupon yield data from January 1986 to March 1996 and estimate the model by applying a Kalman filter that takes into account the model's no-arbitrage restrictions and using only three maturities at a time. The parameter estimates describe a first factor that reverts slowly to a fixed mean and a second factor that reverts relatively quickly to a time-varying mean serving as the third factor. The estimates are robust to the choice of maturities, suggesting that these factors give us an adequate model.

Suggested Citation

  • Frank F. Gong & Eli M. Remolona, 1997. "A three-factor econometric model of the U.S. term structure," Research Paper 9619, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednrp:9619
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    Cited by:

    1. Cassola, N. & Luis, J.B., 2001. "A Two-Factor Model of the German Term Structure of Interest Rates," Papers 46, Quebec a Montreal - Recherche en gestion.
    2. Tobias Adrian & Hao Wu, 2009. "The term structure of inflation expectations," Staff Reports 362, Federal Reserve Bank of New York.
    3. LuisM. Viceira & John Y. Campbell, 2001. "Who Should Buy Long-Term Bonds?," American Economic Review, American Economic Association, vol. 91(1), pages 99-127, March.
    4. Tkacz, Greg, 2004. "Inflation changes, yield spreads, and threshold effects," International Review of Economics & Finance, Elsevier, vol. 13(2), pages 187-199.
    5. Michael J. Fleming & Eli M. Remolona, 1999. "The term structure of announcement effects," Staff Reports 76, Federal Reserve Bank of New York.
    6. Des Mc Manus & David Watt, 1999. "Estimating One-Factor Models of Short-Term Interest Rates," Staff Working Papers 99-18, Bank of Canada.
    7. Kozicki, Sharon & Tinsley, P. A., 2001. "Shifting endpoints in the term structure of interest rates," Journal of Monetary Economics, Elsevier, vol. 47(3), pages 613-652, June.
    8. 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.

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