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Predictability of Interest Rates and Interest-Rate Portfolios

Turan G. Bali
CUNY Baruch College - Zicklin School of Business

Massoud Heidari
Caspian Capital Management, LLC

Liuren Wu
City University of New York, CUNY Baruch College - Zicklin School of Business


June 14, 2006


Abstract:     
Due to the near unit-root behavior of interest rates, the movements of individual interest-rate series are inherently difficult to forecast. In this paper, we propose an innovative way of applying dynamic term structure models to forecast interest-rate movements. Instead of directly forecasting the movements based on the estimated factor dynamics, we use the dynamic term structure model as a decomposition tool and decompose each interest-rate series into two components: a persistent component captured by the dynamic factors, and a strongly mean-reverting component given by the pricing residuals of the model. With this decomposition, we form interest-rate portfolios that are first-order neutral to the persistent dynamic factors, but are fully exposed to the strongly mean-reverting residuals. We show that the predictability of these interest-rate portfolios is significant both statistically and economically, both in sample and out of sample.

Keywords: Term structure, Predictability, Interest rates, Factors, Pricing errors, Expectation hypotheses

JEL Classifications: E43, G11, G12, C51

Working Paper Series

Date posted: August 03, 2006 ; Last revised: August 03, 2006

Suggested Citation

Bali, Turan G., Heidari, Massoud and Wu, Liuren, Predictability of Interest Rates and Interest-Rate Portfolios (June 14, 2006). Available at SSRN: http://ssrn.com/abstract=920673


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Contact Information

Liuren Wu (Contact Author)
City University of New York, CUNY Baruch College - Zicklin School of Business ( email )
One Bernard Baruch Way
Box B10-225
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)
HOME PAGE: http://faculty.baruch.cuny.edu/lwu/
Turan G. Bali
CUNY Baruch College - Zicklin School of Business ( email )
One Bernard Baruch Way, Box 10-225
Department of Finance
New York, NY 10010
United States
646-312-3506 (Phone)
646-312-3451 (Fax)
HOME PAGE: http://faculty.baruch.cuny.edu/tbali
Massoud Heidari
Caspian Capital Management, LLC ( email )
New York, NY 10151
United States
212-703-0300 (Phone)
212-703-0310 (Fax)
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