Nelson-Siegel Decay Factor and Term Premia in Japan

Abstract

This study examines the two-decade-long low interest rate environment in Japan using the Nelson-Siegel yield curve framework emphasizing the role of decay factor. We find that the decay factor has declined particularly after the global financial crisis, pushing down the entire yield curve as well as the conditional variance of bond yield in Japan. The decay factor was very low when BOJ’s yield curve control started in 2016 and remained low with small fluctuations since. Decay factor shocks can be interpreted as long-dated term premium shocks, and these shocks tend to decrease with BOJ’s bond purchases, controlling for other possible factors that affect term premia such as business cycles and economic uncertainty.

Keywords: decay factor, Nelson Siegel, term premium, yield curve control, Japan, nonlinear state space model

JEL Classification: E58, E52, C32