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The Dynamics of Economic Functions: Modelling and Forecasting the Yield Curve

  • Clive G. Bowsher
  • Roland Meeks

The class of Functional Signal plus Noise (FSN) models is introduced that provides a new, general method for modelling and forecasting time series of economic functions.� The underlying, continuous economic function (or 'signal') is a natural cubic spline whose dynamic evolution is driven by a cointegrated vector autoregression for the ordinates (or 'y-values') at the knots of the spline.� The natural cubic spline provides flexible cross-sectional fit and results in a linear, state space model.� This FSN model achieves dimension reduction, provides a coherent description of the observed yield curve and its dynamics as the cross-sectional dimension N becomes large, and can feasibly be estimated and used for forecasting when N is large.� The integration and cointegration properties of the model are derived.� The FSN models are then applied to forecasting 36-dimensional yield curves for US Treasury bonds at the one month ahead horizon.� The method consistently outperforms the Diebold and Li (2006) and random walk forecasts on the basis of both mean square forecast error criteria and economically relevant loss functions derived from the realised profits of pairs trading algorithms.� The analysis also highlights in a concrete setting the dangers of attempts to infer the relative economic value of model forecasts on the basis of their associated mean square forecast errors.

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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 2008-WO5.

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Date of creation: 01 Mar 2008
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Handle: RePEc:oxf:wpaper:2008-wo5
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  1. 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 116-26, February.
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  8. Zellner, A., 1992. "Statistics, Science and Public Policy," Papers 92-21, California Irvine - School of Social Sciences.
  9. Francis X. Diebold & Canlin Li, 2002. "Forecasting the Term Structure of Government Bond Yields," Center for Financial Institutions Working Papers 02-34, Wharton School Center for Financial Institutions, University of Pennsylvania.
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  14. Clive G. Bowsher, 2004. "Modelling the Dynamics of Cross-Sectional Price Functions: an Econometric Analysis of the Bid and Ask Curves of an Automated Exchange," Economics Papers 2004-W21, Economics Group, Nuffield College, University of Oxford.
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  18. Marius Ooms & Bj�rn de Groot & Siem Jan Koopman, 1999. "Time-Series Modelling of Daily Tax Revenues," Computing in Economics and Finance 1999 312, Society for Computational Economics.
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  25. DeRossi, G. & Harvey, A., 2006. "Time-Varying Quantiles," Cambridge Working Papers in Economics 0649, Faculty of Economics, University of Cambridge.
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