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High Dimensional Yield Curves: Models and Forecasting

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  • Clive Bowsher

    () (Nuffield College, University of Oxford)

  • Roland Meeks

    () (Nuffield College, University of Oxford)

Abstract

Functional Signal plus Noise (FSN) models are proposed for analysing the dynamics of a large cross-section of yields or asset prices in which contemporaneous observations are functionally related. The FSN models are used to forecast high dimensional yield curves for US Treasury bonds at the one month ahead horizon. The models achieve large reductions in mean square forecast errors relative to a random walk for yields and readily dominate both the Diebold and Li (2006) and random walk forecasts across all maturities studied. We show that the Expectations Theory (ET) of the term structure completely determines the conditional mean of any zero-coupon yield curve. This enables a novel evaluation of the ET in which its 1-step ahead forecasts are compared with those of rival methods such as the FSN models, with the results strongly supporting the growing body of empirical evidence against the ET. Yield spreads do provide important information for forecasting the yield curve, especially in the case of shorter maturities, but not in the manner prescribed by the Expectations Theory.

Suggested Citation

  • Clive Bowsher & Roland Meeks, 2006. "High Dimensional Yield Curves: Models and Forecasting," Economics Papers 2006-W12, Economics Group, Nuffield College, University of Oxford.
  • Handle: RePEc:nuf:econwp:0612
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    References listed on IDEAS

    as
    1. 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.
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    6. Shea, Gary S, 1992. "Benchmarking the Expectations Hypothesis of the Interest-Rate Term Structure: An Analysis of Cointegration Vectors," Journal of Business & Economic Statistics, American Statistical Association, vol. 10(3), pages 347-366, July.
    7. Hall, Anthony D & Anderson, Heather M & Granger, Clive W J, 1992. "A Cointegration Analysis of Treasury Bill Yields," The Review of Economics and Statistics, MIT Press, vol. 74(1), pages 116-126, February.
    8. 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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    10. John Y. Campbell & Robert J. Shiller, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Review of Economic Studies, Oxford University Press, vol. 58(3), pages 495-514.
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    Cited by:

    1. Almeida, Caio & Vicente, José, 2008. "The role of no-arbitrage on forecasting: Lessons from a parametric term structure model," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2695-2705, December.
    2. Siem Jan Koopman & Max I.P. Mallee & Michel van der Wel, 2007. "Analyzing the Term Structure of Interest Rates using the Dynamic Nelson-Siegel Model with Time-Varying Parameters," Tinbergen Institute Discussion Papers 07-095/4, Tinbergen Institute.
    3. Song Song & Wolfgang K. Härdle & Ya'acov Ritov, 2014. "Generalized dynamic semi‐parametric factor models for high‐dimensional non‐stationary time series," Econometrics Journal, Royal Economic Society, vol. 17(2), pages 101-131, June.

    More about this item

    Keywords

    Yield curve; term structure; expectations theory; FSN models; functional time series; forecasting; state space form; cubic spline.;

    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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