Term Structure Forecasting: No-Arbitrage Restrictions vs. Large Information Set

35 Pages Posted: 21 May 2008

See all articles by Carlo A. Favero

Carlo A. Favero

Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)

Linlin Niu

Xiamen University - Wang Yanan Institute for Studies in Economics (WISE); Xiamen University - School of Economics

Luca Sala

University of Bocconi - Innocenzo Gasparini Institute for Economic Research (IGIER)

Date Written: March 2007

Abstract

This paper addresses the issue of forecasting the term structure. We provide a unified state-space modelling framework that encompasses different existing discrete-time yield curve models. Within such framework we analyze the impact on forecasting performance of two crucial modelling choices, i.e. the imposition of no-arbitrage restrictions and the size of the information set used to extract factors. Using US yield curve data, we find that: a. macro factors are very useful in forecasting at medium/long forecasting horizon; b. financial factors are useful in short run forecasting; c. no-arbitrage models are effective in shrinking the dimensionality of the parameter space and, when supplemented with additional macro information, are very effective in forecasting; d. within no-arbitrage models, assuming time-varying risk price is more favourable than assuming constant risk price for medium horizon-maturity forecast when yield factors dominate the information set, and for short horizon and long maturity forecast when macro factors dominate the information set; e. however, given the complexity and the highly non-linear parameterization of no-arbitrage models, it is very difficult to exploit within this type of models the additional information offered by large macroeconomic datasets.

Keywords: Factor models, forecasting, large data set, term structure of interest rates, yield curve

JEL Classification: C33, C53, E43, E44

Suggested Citation

Favero, Carlo A. and Niu, Linlin and Sala, Luca, Term Structure Forecasting: No-Arbitrage Restrictions vs. Large Information Set (March 2007). , Vol. , pp. -, 2007. Available at SSRN: https://ssrn.com/abstract=1135448

Carlo A. Favero (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

HOME PAGE: http://www.igier.unibocconi.it\favero

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Linlin Niu

Xiamen University - Wang Yanan Institute for Studies in Economics (WISE) ( email )

A 306, Economics Building
Xiamen, Fujian 361005
China

Xiamen University - School of Economics ( email )

China

Luca Sala

University of Bocconi - Innocenzo Gasparini Institute for Economic Research (IGIER) ( email )

Via Roentgen 1
Milan, 20136
Italy
+39 02 5836 3326 (Phone)

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