A Three-Factor Yield Curve Model: Non-Affine Structure, Systematic Risk Sources, and Generalized Duration

44 Pages Posted: 21 Jun 2006

See all articles by Francis X. Diebold

Francis X. Diebold

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)

Lei Ji

University of Pennsylvania - Department of Economics

Canlin Li

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management

Date Written: March 9, 2004

Abstract

We assess and apply the term-structure model introduced by Nelson and Siegel (1987) and re-interpreted by Diebold and Li (2003) as a modern three-factor model of level, slope and curvature. First, we ask whether the model is a member of the affine class, and we find that it is not. Hence the poor forecasting performance recently documented for affine term structure models in no way implies that our model will forecast poorly, which is consistent with Diebold and Li's (2003) finding that it indeed forecasts quite well. Next, having clarified the relationship between our three-factor model and the affine class, we proceed to assess its adequacy directly, by testing whether its level, slope and curvature factors do indeed capture systematic risk. We find that they do, and that they are therefore priced. Finally, confident in the ability of our three-factor model to capture the pricing relations present in the data, we proceed to explore its efficacy in bond portfolio risk management. Traditional Macaulay duration is appropriate only in a one-factor (level) context; hence we move to a three-factor generalized duration, and we show the superior performance of hedges constructed using it.

Keywords: Term structure; Yield curve; Factor model; Risk Management

JEL Classification: G1, E43, E47, C5

Suggested Citation

Diebold, Francis X. and Ji, Lei and Li, Canlin, A Three-Factor Yield Curve Model: Non-Affine Structure, Systematic Risk Sources, and Generalized Duration (March 9, 2004). PIER Working Paper No. 06-017. Available at SSRN: https://ssrn.com/abstract=910218 or http://dx.doi.org/10.2139/ssrn.910218

Francis X. Diebold

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
133 South 36th Street
Philadelphia, PA 19104-6297
United States
215-898-1507 (Phone)
215-573-4217 (Fax)

HOME PAGE: http://www.ssc.upenn.edu/~fdiebold/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Lei Ji

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
133 South 36th Street
Philadelphia, PA 19104-6297
United States

Canlin Li (Contact Author)

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management ( email )

Riverside, CA 92521
United States
951-8272325 (Phone)

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