No-Arbitrage Priors, Drifting Volatilities, and the Term Structure of Interest Rates

40 Pages Posted: 22 Sep 2020

See all articles by Andrea Carriero

Andrea Carriero

Queen Mary, University of London

Todd E. Clark

Federal Reserve Bank of Cleveland

Massimiliano Giuseppe Marcellino

Bocconi University - Department of Economics; Centre for Economic Policy Research (CEPR)

Date Written: September 22, 2020

Abstract

We derive a Bayesian prior from a no-arbitrage affine term structure model and use it to estimate the coefficients of a vector autoregression of a panel of government bond yields, specifying a common time-varying volatility for the disturbances. Results based on US data show that this method improves the precision of both point and density forecasts of the term structure of government bond yields, compared to a fully fledged term structure model with time-varying volatility and to a no-change random walk forecast. Further analysis reveals that the approach might work better than an exact term structure model because it relaxes the requirements that yields obey a strict factor structure and that the factors follow a Markov process. Instead, the cross-equation no-arbitrage restrictions on the factor loadings play a marginal role in producing forecasting gains.

Keywords: term structure, volatility, density forecasting, no arbitrage

JEL Classification: C32, C53, E43, E47, G12

Suggested Citation

Carriero, Andrea and Clark, Todd E. and Marcellino, Massimiliano, No-Arbitrage Priors, Drifting Volatilities, and the Term Structure of Interest Rates (September 22, 2020). Available at SSRN: https://ssrn.com/abstract=3697336 or http://dx.doi.org/10.2139/ssrn.3697336

Andrea Carriero

Queen Mary, University of London ( email )

Mile End Road
London, London E1 4NS
United Kingdom

Todd E. Clark (Contact Author)

Federal Reserve Bank of Cleveland ( email )

P.O. Box 6387
Cleveland, OH 44101
United States
216-579-2015 (Phone)

Massimiliano Marcellino

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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