Tractable Term Structure Models
54 Pages Posted: 22 Nov 2015 Last revised: 1 Aug 2019
Date Written: December 14, 2018
Interest rate forecasting remains vexing because of the lower bound. A few tractable models are available, but they offer limited or restrictive volatility dynamics. In response, we build on the popular dynamic Nelson-Siegel approach to greatly expand the space of term-structure models that are tractable and with realistic dynamics. Our approach directly specifies closed-form bond prices and delivers a rich family of non-linear models that, importantly, we can transform into the linear space for efficient, instantaneous estimation. Pragmatic real-time interest rate forecasting is then feasible for non-linear models in a manner very challenging for harder-to-estimate traditional non-linear no-arbitrage models. As a practically relevant example, we implement a tractable specification that incorporates the lower bound and time-varying volatility, but improves the forecast accuracy of bond returns, volatilities, and Sharpe ratios.
Keywords: Term-Structure, Lower Bound, No-Arbitrage, Forecasting
JEL Classification: G12
Suggested Citation: Suggested Citation