Shrinking the Term Structure

70 Pages Posted: 8 Aug 2022 Last revised: 12 May 2023

See all articles by Damir Filipović

Damir Filipović

École Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Markus Pelger

Stanford University - Department of Management Science & Engineering

Ye Ye

Stanford University

Date Written: August 4, 2022

Abstract

We develop a conditional factor model for the term structure of Treasury bonds, which unifies non parametric curve estimation with cross-sectional asset pricing. Our factors are investable portfolios and estimated with cross-sectional ridge regressions. They correspond to the optimal non parametric basis functions that span the discount curve and are based on economic first principles. Cash flows are covariances, which fully explain the factor exposure of coupon bonds. Empirically, we show that four factors explain the discount bond excess return curve and term structure premium, which depends on the market complexity measured by the time-varying importance of higher order factors. The fourth term structure factor capturing complex shapes of the term structure premium is a hedge for bad economic times and pays off during recessions.

Keywords: Term structure of interest rates, bond returns, factor space, U.S. Treasury securities, non-parametric method, principal components, machine learning in finance, reproducing kernel Hilbert space

JEL Classification: C14, C38, C55, G12

Suggested Citation

Filipovic, Damir and Pelger, Markus and Ye, Ye, Shrinking the Term Structure (August 4, 2022). Swiss Finance Institute Research Paper No. 61, 2022, Available at SSRN: https://ssrn.com/abstract=4182649 or http://dx.doi.org/10.2139/ssrn.4182649

Damir Filipovic (Contact Author)

École Polytechnique Fédérale de Lausanne ( email )

Odyssea
Station 5
Lausanne, 1015
Switzerland

HOME PAGE: http://people.epfl.ch/damir.filipovic

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Markus Pelger

Stanford University - Department of Management Science & Engineering ( email )

473 Via Ortega
Stanford, CA 94305-9025
United States

Ye Ye

Stanford University ( email )

Stanford, CA 94305
United States

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