A Three-Factor Econometric Model of the U.S. Term Structure

Federal Reserve Bank of New York Staff Report No. 19

Posted: 22 Feb 1998

See all articles by Frank F. Gong

Frank F. Gong

Bank of America - Bank of America, Hong Kong

Eli M. Remolona

Bank for International Settlements (BIS) - Monetary and Economic Department

Multiple version iconThere are 2 versions of this paper

Date Written: January 1997

Abstract

We estimate a three-factor model to fit both the time-series dynamics and cross-sectional shapes of the U.S. term structure. In the model, three unobserved factors drive a discrete-time stochastic discount process, with one factor reverting to a fixed mean and a second factor reverting to a third factor. To exploit the conditional density of yields, we estimate the model with a Kalman filter, a procedure that also allows us to use data for six maturities without making special assumptions about measurement errors. The estimated model reproduces the basic shapes of the average term structure, including the hump in the yield curve and the flat slope of the volatility curve. A likelihood ratio test favors the model over a nested two-factor model. Another likelihood ratio test, however, rejects the no-arbitrage restrictions the model imposes on the estimates. An analysis of the measurement errors suggests that the three factors still fail to capture enough of the comovement and persistence of yields.

JEL Classification: E43, G12, G13

Suggested Citation

Gong, Frank F. and Remolona, Eli M., A Three-Factor Econometric Model of the U.S. Term Structure (January 1997). Federal Reserve Bank of New York Staff Report No. 19, Available at SSRN: https://ssrn.com/abstract=47187

Frank F. Gong

Bank of America - Bank of America, Hong Kong

Hong Kong
Hong Kong

Eli M. Remolona (Contact Author)

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

IFC 2 Bldg, 78/F
Central
Hong Kong
Hong Kong
+852 2982 7150 (Phone)
+852 2982 7123 (Fax)

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