Pricing the Term Structure with Linear Regressions
68 Pages Posted: 22 Mar 2009 Last revised: 7 May 2013
Date Written: April 11, 2013
We show how to price the time series and cross-section of the term structure of interest rates using a three-step linear regression approach. Our method allows computationally fast estimation of term structure models with a large number of pricing factors. We present specification tests favoring a model using five principal components of yields as factors. We demonstrate that this model outperforms the Cochrane and Piazzesi (2008) four-factor specification in out-of-sample exercises but generates similar in-sample term premium dynamics. Our regression approach can also incorporate unspanned factors and allows estimation of term structure models without observing a zero-coupon yield curve.
Keywords: term structure of interest rates, Fama-MacBeth regressions, dynamic asset pricing model estimation
JEL Classification: G10, G12, E43
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