The Efficacy of Term Structure Estimation Technique: A Monte Carlo Study

The Journal of Fixed Income, Vol. 2, No. 1, pp. 52-63, March 1992

12 Pages Posted: 5 Mar 2008 Last revised: 8 Oct 2013

See all articles by Mark J. Buono

Mark J. Buono

Independent

Russell B. Gregory-Allen

Massey University - Department of Commerce

Uzi Yaari

Rutgers University; School of Business-Camden

Abstract

The term structure of default-free interest rates is not directly observable in a market where government obligations of various maturities bear coupons at different rates, and where ordinary income and capital gains are subject to unknown and varying effective tax rates. Accurate knowledge of the term structure of spot rates and underlying forward rates is essential for financial research and practice. There are various methods for empirically estimating forward rates and numerous studies that test the accuracy of those methods. Yet, that accuracy cannot be ascertained without knowledge of the true underlying forward rates or the error distribution of those rates. With an unknown error distribution, the statistical estimation of forward rates may be biased. This study offers two innovations designed to improve term structure estimation. First, we use Monte Carlo simulation to generate data with known parameters, which are free of unknown biases. The synthetic data are used to test and compare the accuracy of competing methods in estimating the known forward rates. Second, the knowledge obtained from such tests should enable researchers and practitioners to select the best method for estimating unknown forward rates from empirical data. In contrast, estimation methods are currently selected based on their power to explain variations in bond prices. We provide evidence that the two procedures are poor substitutes. While a variety of estimation methods are good at explaining variations in bond prices, our findings reveal considerable differences among widely known methods in their ability to estimate forward rates.

Keywords: government forward rates, term structure estimation methods, risk-free interest rates

JEL Classification: C13, C15, C52, C53, G12, G10

Suggested Citation

Buono, Mark J. and Gregory-Allen, Russell B. and Yaari, Uzi, The Efficacy of Term Structure Estimation Technique: A Monte Carlo Study. The Journal of Fixed Income, Vol. 2, No. 1, pp. 52-63, March 1992, Available at SSRN: https://ssrn.com/abstract=1101845

Mark J. Buono

Independent ( email )

Russell B. Gregory-Allen

Massey University - Department of Commerce ( email )

Auckland
New Zealand

Uzi Yaari (Contact Author)

Rutgers University ( email )

School of Business
Camden, NJ 08102
United States
610-664-2086 (Phone)

HOME PAGE: http://camden-sbc.rutgers.edu/FacultyStaff/Directory/yaari.htm

School of Business-Camden ( email )

Rutgers University
227 Penn Street
Camden, NJ 08102
United States
610-664-2086 (Phone)
610-664-2198 (Fax)

HOME PAGE: http://camden-sbc.rutgers.edu/FacultyStaff/Directory/yaari.htm

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