Yield Curve Factors, Factor Volatilities, and the Predictability of Bond Excess Returns

44 Pages Posted: 26 Mar 2008 Last revised: 30 Oct 2008

See all articles by Nikolaus Hautsch

Nikolaus Hautsch

University of Vienna - Department of Statistics and Operations Research; Center for Financial Studies (CFS); Vienna Graduate School of Finance (VGSF)

Yangguoyi Ou

Humboldt University of Berlin - School of Business and Economics

Date Written: March 17, 2008

Abstract

We introduce a Nelson-Siegel type interest rate term structure model with the underlying yield factors following autoregressive processes revealing time-varying stochastic volatility. The factor volatilities capture risk inherent to the term structure and are associated with the time-varying uncertainty of the yield curve's level, slope and curvature. Estimating the model based on U.S. government bond yields applying Markov chain Monte Carlo techniques we find that the yield factors and factor volatilities follow highly persistent processes. Using the extracted factors to explain one-year-ahead bond excess returns we observe that the slope and curvature yield factors contain the same explanatory power as the return-forecasting factor recently proposed by Cochrane and Piazzesi (2005). Moreover, we identify slope and curvature risk as important additional determinants of future excess returns. Finally, we illustrate that the yield and volatility factors are closely connected to variables reflecting macroeconomic activity, inflation, monetary policy and employment growth. It is shown that the extracted yield curve components have long-term prediction power for macroeconomic fundamentals.

Keywords: Term Structure Modelling; Yield Curve Risk; Stochastic Volatility; Factor Models; Macroeconomic Fundamentals

JEL Classification: C5, E4, G1

Suggested Citation

Hautsch, Nikolaus and Ou, Yangguoyi, Yield Curve Factors, Factor Volatilities, and the Predictability of Bond Excess Returns (March 17, 2008). Available at SSRN: https://ssrn.com/abstract=1107488 or http://dx.doi.org/10.2139/ssrn.1107488

Nikolaus Hautsch (Contact Author)

University of Vienna - Department of Statistics and Operations Research ( email )

Oskar-Morgenstern-Platz 1
Vienna, A-1090
Austria

Center for Financial Studies (CFS) ( email )

Gr├╝neburgplatz 1
Frankfurt am Main, 60323
Germany

Vienna Graduate School of Finance (VGSF) ( email )

Welthandelsplatz 1
Vienna, 1020
Austria

Yangguoyi Ou

Humboldt University of Berlin - School of Business and Economics ( email )

Spandauer Str. 1
Berlin, D-10099
Germany

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