Tractable Term Structure Models

56 Pages Posted: 22 Nov 2015 Last revised: 16 Dec 2018

See all articles by Bruno Feunou

Bruno Feunou

Bank of Canada

Jean-Sebastien Fontaine

Bank of Canada

Anh Le

Penn State University Smeal College of Business

Christian T. Lundblad

University of North Carolina Kenan-Flagler Business School

Date Written: December 14, 2018

Abstract

Term structure forecasting remains vexing for researchers, investment managers, and central banks because of the zero lower bound bound (ZLB), time-varying volatility and other challenging features. To address these challenges, we greatly expand the space of tractable term-structure models with realistic dynamics. By tractable, we mean highly flexible, yet easy to implement, models that directly specify closed-form bond prices, thereby resembling the approach of Nelson-Siegel (NS). Our proposed models, which admit the dynamic NS model as a special case, nevertheless guarantee the absence of dominant trading strategies. This result helps explain the perception that dynamic NS models are "nearly" free of arbitrage. As an example, we design a tractable model adapted to the ZLB as well as to time-varying volatilities and correlations. In a simulation exercise, we find significant improvements in the forecast accuracy of bond returns, volatilities, and Sharpe ratios. In the data, we find more pronounced dips in the term premium during the early expansionary phase following the end of past recessions.

Keywords: Term Structure, Zero Lower Bound, Stochastic Dominance, No-arbitrage

JEL Classification: G12

Suggested Citation

Feunou, Bruno and Fontaine, Jean-Sebastien and Le, Anh and Lundblad, Christian T., Tractable Term Structure Models (December 14, 2018). Available at SSRN: https://ssrn.com/abstract=2693568 or http://dx.doi.org/10.2139/ssrn.2693568

Bruno Feunou

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-8302 (Phone)

HOME PAGE: http://kamkui.net/

Jean-Sebastien Fontaine (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

HOME PAGE: http://www.jean-sebastienfontaine.com

Anh Le

Penn State University Smeal College of Business ( email )

Business Building
University Park, PA 16801
United States

Christian T. Lundblad

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-8441 (Phone)

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