Tractable Term Structure Models
56 Pages Posted: 22 Nov 2015 Last revised: 16 Dec 2018
Date Written: December 14, 2018
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: Suggested Citation