A Smooth Shadow-Rate Dynamic Nelson-Siegel Model for Yields at the Zero Lower Bound
Tinbergen Institute Discussion Paper 2022-011/III
56 Pages Posted: 19 Mar 2022 Last revised: 12 Apr 2024
Date Written: March 24, 2023
Abstract
We propose a smooth shadow-rate version of the dynamic Nelson-Siegel (DNS) model to analyze the term structure of interest rates during a zero lower bound (ZLB) period. By relaxing the no-arbitrage restriction, our shadow-rate model becomes highly tractable with a closed-form yield curve expression. This permits the implementation of readily available DNS extensions such as allowing for time-varying parameters and the integration of macroeconomic variables. Using U.S. Treasury data, we provide clear evidence of a smooth transition of the yields entering and leaving the ZLB state. Moreover, we show that the smooth shadow-rate DNS model dominates the baseline DNS model and (shadow-rate) affine term structure models in terms of fitting and forecasting the yield curve, while it also produces plausible policy insights at the ZLB.
Keywords: Yield curve, zero lower bound, shadow-rate model, Nelson–Siegel model
JEL Classification: E43, E47, C53, C58, G12
Suggested Citation: Suggested Citation