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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. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," Working Papers 94-09, New York University, Leonard N. Stern School of Business, Department of Economics.
  2. Robin Greenwood & Dimitri Vayanos, 2008. "Bond supply and excess bond returns," LSE Research Online Documents on Economics 24425, London School of Economics and Political Science, LSE Library.
  3. 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.
  4. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1996. "On Biases in Tests of the Expecations Hypothesis of the Term Structure Of Interest Rates," NBER Technical Working Papers 0191, National Bureau of Economic Research, Inc.
  5. Greg Duffee, 2010. "Sharpe ratios in term structure models," Economics Working Paper Archive 575, The Johns Hopkins University,Department of Economics.
  6. Duffee, Gregory R, 1996. " Idiosyncratic Variation of Treasury Bill Yields," Journal of Finance, American Finance Association, vol. 51(2), pages 527-51, June.
  7. Greg Duffee, 2011. "Information in (and not in) the term structure," Economics Working Paper Archive 577, The Johns Hopkins University,Department of Economics.
  8. 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.
  9. 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).
  10. Pagan, A.R. & Hall, A.D. & Martin, V., 1995. "Modelling the Term Structure," Papers 284, Australian National University - Department of Economics.
  11. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
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