Correcting Estimation Bias in Dynamic Term Structure Models
32 Pages Posted: 6 Sep 2013
Date Written: May 4, 2012
The affine dynamic term structure model (DTSM) is the canonical empirical finance representation of the yield curve. However, the possibility that DTSM estimates may be distorted by small-sample bias has been largely ignored. We show that conventional estimates of DTSM coefficients are indeed severely biased, and this bias results in misleading estimates of expected future short-term interest rates and of long-maturity term premia. We provide a variety of bias-corrected estimates of affine DTSMs, both for maximally flexible and over-identified specifications. Our estimates imply short rate expectations and term premia that are more plausible from a macro-finance perspective.
Keywords: small-sample bias correction, vector auto-regression, dynamic term structure models, term premium
JEL Classification: C53, E43, E47
Suggested Citation: Suggested Citation