Yield Curve Prediction for the Strategic Investor

32 Pages Posted: 28 May 2005  

Carlos Bernadell

European Central Bank - Risk Management Division

Joachim Coche

European Central Bank - Risk Management Division

Ken Nyholm

European Central Bank (ECB) - Risk Management Division

Date Written: April 2005

Abstract

This paper presents a new framework allowing strategic investors to generate yield curve projections contingent on expectations about future macroeconomic scenarios. By consistently linking the shape and location of yield curves to the state of the economy our method generates predictions for the full yield-curve distribution under different assumptions on the future state of the economy. On the technical side, our model represents a regime-switching expansion of Diebold and Li (2003) and hence rests on the Nelson-Siegel functional form set in state-space form. We allow transition probabilities in the regime-switching set-up to depend on observed macroeconomic variables and thus create a link between the macro economy and the shape and location of yield curves and their time-series evolution. The model is successfully applied to US yield curve data covering the period from 1953 to 2004 and encouraging out-of-sample results are obtained, in particular at forecasting horizons longer than 24 months.

Keywords: Regime switching, scenario analysis, yield curve distributions, state space model

JEL Classification: C51, C53, E44

Suggested Citation

Bernadell, Carlos and Coche, Joachim and Nyholm, Ken, Yield Curve Prediction for the Strategic Investor (April 2005). ECB Working Paper No. 472. Available at SSRN: https://ssrn.com/abstract=701271

Carlos Bernadell (Contact Author)

European Central Bank - Risk Management Division ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Joachim Coche

European Central Bank - Risk Management Division ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Ken Nyholm

European Central Bank (ECB) - Risk Management Division ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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