An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates

27 Pages Posted: 5 Oct 2005

See all articles by Don H. Kim

Don H. Kim

Board of Governors of the Federal Reserve System

Jonathan H. Wright

Johns Hopkins University - Department of Economics

Date Written: August 2005

Abstract

This paper reviews a simple three-factor arbitrage-free term structure model estimated by Federal Reserve Board staff and reports results obtained from fitting this model to U.S. Treasury yields since 1990. The model ascribes a large portion of the decline in long-term yields and distant-horizon forward rates since the middle of 2004 to a fall in term premiums. A variant of the model that incorporates inflation data indicates that about two-thirds of the decline in nominal term premiums owes to a fall in real term premiums, but estimated compensation for inflation risk has diminished as well.

Keywords: Forward rates, term-structure model, arbitrage-free pricing, term premiums

JEL Classification: E43

Suggested Citation

Kim, Don H. and Wright, Jonathan H., An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates (August 2005). FEDS Working Paper No. 2005-33, Available at SSRN: https://ssrn.com/abstract=813267 or http://dx.doi.org/10.2139/ssrn.813267

Don H. Kim

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Jonathan H. Wright (Contact Author)

Johns Hopkins University - Department of Economics ( email )

3400 Charles Street
Baltimore, MD 21218-2685
United States

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