Term Premium in a Fractionally Cointegrated Yield Curve

Abstract

The co-movement of US sovereign rates suggests a long-run equilibrium relationship.
Traditional cointegrated systems need to assume that interest rates are unit roots and thus implying non-stationary and non-mean-reverting dynamics. We postulate and estimate a fractional cointegrated model (FCVAR) which allows for mean reverting though highly persistent patterns. Our results point to the existence of such mean-reverting fractional cointegration among sovereign rates. In terms of out-of-sample forecasting, the FCVAR soundly beats the I(0) VAR model across interest rate maturities and horizons and the I(1) cointegrated VAR across maturities and short-horizons. The implied US term premium --across different maturities-- proves to be quite robust across subsamples and is less volatile than the classical I(0) stationary and I(1) unit root models. Our analysis highlights the role of real factors in shaping term premium dynamics and is extended to the UK and Germany yield curves.

Keywords: U.S. yield curve, stochastic trend, fractional cointegration, term premium, international yield curves

JEL Classification: C2, C3, E4, G1