A Dynamic Model for the Forward Curve

The Rodney L. White Center for Financial Research Working Paper No. 34-05

61 Pages Posted: 11 Nov 2005

See all articles by Choong Tze Chua

Choong Tze Chua

Singapore Management University

Dean P. Foster

University of Pennsylvania - Statistics Department

Krishna Ramaswamy

University of Pennsylvania - Finance Department

Robert A. Stine

University of Pennsylvania - Statistics Department

Multiple version iconThere are 2 versions of this paper

Date Written: September 2005

Abstract

This paper develops and estimates a dynamic arbitrage-free model for the current forward curve as the sum of (i) an unconditional component, (ii) a maturity-specific component and (iii) a date-specific component. The model combines features of the Preferred Habitat model,the Expectation Hypothesis and affine yield curve models. We show how to construct alternative parametric examples of the three components from a sum of exponential functions, verify that the resulting forward curves satisfy the Heath-Jarrow-Morton conditions, and derive the risk-neutral dynamics for the purpose of pricing interest rate derivatives. We select a model from alternative affine examples that are fitted to the Fama-Bliss Treasury data over an initial training period and use it to generate out-of-sample forecasts for forward rates and yields. For forecast horizons of 6-months or longer, the forecasts of this model significantly outperform forecasts from common benchmark models.

Suggested Citation

Chua, Choong Tze and Foster, Dean P. and Ramaswamy, Krishna and Stine, Robert A., A Dynamic Model for the Forward Curve (September 2005). The Rodney L. White Center for Financial Research Working Paper No. 34-05, Available at SSRN: https://ssrn.com/abstract=842204 or http://dx.doi.org/10.2139/ssrn.842204

Choong Tze Chua

Singapore Management University ( email )

50 Stamford Rd.
Singapore 912409, 178899
Singapore

Dean P. Foster

University of Pennsylvania - Statistics Department ( email )

Wharton School
Philadelphia, PA 19104
United States

Krishna Ramaswamy (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

Robert A. Stine

University of Pennsylvania - Statistics Department ( email )

Wharton School
Philadelphia, PA 19104
United States

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