The Role of No-Arbitrage on Forecasting: Lessons from a Parametric Term Structure Model

34 Pages Posted: 21 Mar 2018

See all articles by Caio Almeida

Caio Almeida

Getulio Vargas Foundation ; Princeton University

Jose Vicente

Government of the Federative Republic of Brazil - Central Bank of Brazil; Ibmec, Rio de Janeiro - IBMEC Business School

Date Written: June 15, 2008

Abstract

Parametric term structure models have been successfully applied to numerous problems in fixed income markets, including pricing, hedging, managing risk, as well as to the study of monetary policy implications. In turn, dynamic term structure models, equipped with stronger economic structure, have been mainly adopted to price derivatives and explain empirical stylized facts. In this paper, we combine flavors of those two classes of models to test whether no-arbitrage affects forecasting. We construct cross-sectional (allowing arbitrages) and arbitrage-free versions of a parametric polynomial model to analyze how well they predict out-of-sample interest rates. Based on U.S. Treasury yield data, we find that no-arbitrage restrictions significantly improve forecasts. Arbitrage-free versions achieve overall smaller biases and root mean square errors for most maturities and forecasting horizons. Furthermore, a decomposition of forecasts into forward-rates and holding return premia indicates that the superior performance of no-arbitrage versions is due to a better identification of bond risk premium.

Keywords: Dynamic models, No-arbitrage, Forecasting, Bond risk premia

JEL Classification: G12, C51 , C53

Suggested Citation

Almeida, Caio and Vicente, Jose, The Role of No-Arbitrage on Forecasting: Lessons from a Parametric Term Structure Model (June 15, 2008). Available at SSRN: https://ssrn.com/abstract=3142987 or http://dx.doi.org/10.2139/ssrn.3142987

Caio Almeida (Contact Author)

Getulio Vargas Foundation ( email )

Praia de Botafogo 190, 11o andar
Botafogo
Rio de Janeiro, Rio de Janeiro 22250-900
Brazil
5521-37995827 (Phone)
5521-2553-8821 (Fax)

HOME PAGE: http://www.fgv.br/professor/calmeida/

Princeton University ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States

Jose Vicente

Government of the Federative Republic of Brazil - Central Bank of Brazil

P.O. Box 08670
SBS Quadra 3 Bloco B - Edificio-Sede
Brasilia, Distr. Federal 70074-900
Brazil

Ibmec, Rio de Janeiro - IBMEC Business School

SCN Quadra 2, Bloco A, 2nd. floor
Ed. Corporate Financial Center
Brasília, 707712-900
Brazil

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