A Dynamic Model for the Forward Curve

Posted: 26 Jun 2008

See all articles by Choong Tze Chua

Choong Tze Chua

Singapore Management University

Dean P. Foster

University of Pennsylvania - Statistics Department

Krishna Ramaswamy

University of Pennsylvania - Finance Department

Multiple version iconThere are 2 versions of this paper

Date Written: January 2008

Abstract

This article develops and estimates a dynamic arbitrage-free model of the current forward curve as the sum of (i) an unconditional component, (ii) a maturity-specific component and (iii) a date-specific component. The model combines features of the Preferred Habitat model, the Expectations Hypothesis (ET) and affine yield curve models; it permits a class of low-parameter, multiple state variable dynamic models for the forward curve. We show how to construct alternative parametric examples of the three components from a sum of exponential functions, verify that the resulting forward curves satisfy the Heath-Jarrow-Morton (HJM) conditions, and derive the risk-neutral dynamics for the purpose of pricing interest rate derivatives. We select a model from alternative affine examples that are fitted to the Fama-Bliss Treasury data over an initial training period and use it to generate out-of-sample forecasts for forward rates and yields. For forecast horizons of 6 months or longer, the forecasts of this model significantly outperform those from common benchmark models.

JEL Classification: C53, E43, E47

Suggested Citation

Chua, Choong Tze and Foster, Dean P. and Ramaswamy, Krishna, A Dynamic Model for the Forward Curve (January 2008). The Review of Financial Studies, Vol. 21, Issue 1, pp. 265-310, 2008, Available at SSRN: https://ssrn.com/abstract=1151576 or http://dx.doi.org/10.1093/rfs/hhm039

Choong Tze Chua (Contact Author)

Singapore Management University ( email )

50 Stamford Rd.
Singapore 912409, 178899
Singapore

Dean P. Foster

University of Pennsylvania - Statistics Department ( email )

Wharton School
Philadelphia, PA 19104
United States

Krishna Ramaswamy

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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