Staying on Top of the Curve: A Cascade Model of Term Structure Dynamics

55 Pages Posted: 17 Mar 2010 Last revised: 16 Apr 2013

See all articles by Laurent E. Calvet

Laurent E. Calvet

EDHEC Business School - Department of Economics & Finance; CEPR

Adlai J. Fisher

University of British Columbia (UBC) - Sauder School of Business

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Date Written: April 16, 2013

Abstract

We model term structure dynamics using a recursive cascade of heterogeneously persistent factors. The cascade naturally orders the factors by their adjustment speeds, and generates smooth zero-coupon bond prices and forward curves in closed form. For a class of specifications, the number of parameters is invariant to the size of the state space, and the term structure converges to a stochastic limit as the number of factors goes to infinity. The cascade construction thereby defeats the curse of dimensionality associated with general affine models. Using a panel of interest rates, we estimate specifications with from one to 15 factors and only five parameters. High-dimensional versions of the model fit empirical yield curves almost perfectly in sample, with root mean squared errors of less than one basis point, while maintaining reasonable maximal Sharpe ratios. Out-of-sample interest rate forecasts significantly outperform prior benchmarks.

Keywords: Term structure of interest rates, cascade model, dimension-invariance, interest rate forecasting, yield curve stripping, forward rate correlations

JEL Classification: E43, E47, G10, G12, C51

Suggested Citation

Calvet, Laurent E. and Fisher, Adlai J. and Wu, Liuren, Staying on Top of the Curve: A Cascade Model of Term Structure Dynamics (April 16, 2013). Available at SSRN: https://ssrn.com/abstract=1573392 or http://dx.doi.org/10.2139/ssrn.1573392

Laurent E. Calvet (Contact Author)

EDHEC Business School - Department of Economics & Finance ( email )

France

CEPR ( email )

33 Great Sutton Street
London, EC1V 0DX
United Kingdom

Adlai J. Fisher

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-8331 (Phone)
604-822-4695 (Fax)

HOME PAGE: http://finance.sauder.ubc.ca/~fisher

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

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