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Forecasting with the term structure: The role of no-arbitrage restrictions

  • Greg Duffee

No-arbitrage term structure models impose cross-sectional restrictions among yields and can be used to impose dynamic restrictions on risk compensation. This paper evaluates the importance of these restrictions when using the term structure to forecast future bond yields. It concludes that no cross-sectional restrictions are helpful, because cross-sectional properties of yields are easy to infer with high precision. Dynamic restrictions are useful, but can be imposed without relying on the no-arbitrage structure. In practice, the most important dynamic restriction is that the first principal component of Treasury yields follows a random walk. A simple model built around this assumption produces out-of-sample forecasts that are more accurate than those of a variety of alternative dynamic models.

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Paper provided by The Johns Hopkins University,Department of Economics in its series Economics Working Paper Archive with number 576.

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Date of creation: Jan 2011
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Handle: RePEc:jhu:papers:576
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  1. Greg Duffee, 2011. "Information in (and not in) the term structure," Economics Working Paper Archive 577, The Johns Hopkins University,Department of Economics.
  2. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," NBER Working Papers 4676, National Bureau of Economic Research, Inc.
  3. Gregory R. Duffee, 1994. "Idiosyncratic variation of Treasury bill yields," Finance and Economics Discussion Series 94-28, Board of Governors of the Federal Reserve System (U.S.).
  4. Jens H. E. Christensen & Francis X. Diebold & Glenn D. Rudebusch, 2007. "The Affine Arbitrage-Free Class of: Nelson-Siegel Term Structure Models," NBER Working Papers 13611, National Bureau of Economic Research, Inc.
  5. Dimitri Vayanos & Robin Greenwood, 2008. "Bond Supply and Excess Bond Returns," FMG Discussion Papers dp607, Financial Markets Group.
  6. Diebold, Francis X. & Li, Canlin, 2003. "Forecasting the term structure of government bond yields," CFS Working Paper Series 2004/09, Center for Financial Studies (CFS).
  7. Geert Bekaert & Robert J. Hodrick & David Marshall, 1996. "On biases in tests of the expectations hypothesis of the term structure of interest rates," Working Paper Series, Issues in Financial Regulation WP-96-3, Federal Reserve Bank of Chicago.
  8. Pagan, A.R. & Hall, A.D. & Martin, V., 1995. "Modelling the Term Structure," Papers 284, Australian National University - Department of Economics.
  9. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  10. Andrew Ang & Monika Piazzesi, 2001. "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables," NBER Working Papers 8363, National Bureau of Economic Research, Inc.
  11. Greg Duffee, 2010. "Sharpe ratios in term structure models," Economics Working Paper Archive 575, The Johns Hopkins University,Department of Economics.
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