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

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  • Greg Duffee

Abstract

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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  • Greg Duffee, 2011. "Forecasting with the term structure: The role of no-arbitrage restrictions," Economics Working Paper Archive 576, The Johns Hopkins University,Department of Economics.
  • Handle: RePEc:jhu:papers:576
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    1. Christensen, Jens H.E. & Diebold, Francis X. & Rudebusch, Glenn D., 2011. "The affine arbitrage-free class of Nelson-Siegel term structure models," Journal of Econometrics, Elsevier, vol. 164(1), pages 4-20, September.
    2. Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 1997. "On biases in tests of the expectations hypothesis of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 44(3), pages 309-348, June.
    3. 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.
    4. Diebold, Francis X. & Li, Canlin, 2006. "Forecasting the term structure of government bond yields," Journal of Econometrics, Elsevier, vol. 130(2), pages 337-364, February.
    5. Robin Greenwood & Dimitri Vayanos, 2014. "Bond Supply and Excess Bond Returns," Review of Financial Studies, Society for Financial Studies, vol. 27(3), pages 663-713.
    6. Pagan, A.R. & Hall, A.D. & Martin, V., 1995. "Modelling the Term Structure," Papers 284, Australian National University - Department of Economics.
    7. Duffee, Gregory R, 1996. " Idiosyncratic Variation of Treasury Bill Yields," Journal of Finance, American Finance Association, vol. 51(2), pages 527-551, June.
    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, February.
    9. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," NBER Working Papers 4676, National Bureau of Economic Research, Inc.
    10. Gregory R. Duffee, 2011. "Information in (and not in) the Term Structure," Review of Financial Studies, Society for Financial Studies, vol. 24(9), pages 2895-2934.
    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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