Modeling and Forecasting the Term Structure of Government Bond Yields

• Activity Number: 94
• Type: Topic Contributed
• Date/Time: Monday, August 12, 2002 : 10:30 AM to 12:20 PM
• Sponsor: Business & Economics Statistics Section*
• Author(s): Canlin Li*+ and Francis Diebold
• Affiliation(s): University of Pennsylvania and University of Pennsylvania
• Keywords: term structure ; forecasting ; duration

Abstract

Despite powerful advances in yield curve modeling in the last twenty years, little attention has been paid to the key practical problem of forecasting the yield curve. In this paper we do so. We use variations on the Nelson-Siegel exponential components framework to model the entire yield curve, period-by-period, as a three-dimensional parameter evolving dynamically. We show that the three time-varying parameters may be interpreted as factors corresponding to level, slope, and curvature, and that they may be estimated with high efficiency. We propose and estimate autoregressive models for the factors, and we show that our models are consistent with a variety of stylized facts regarding the yield curve. We use our models to produce term structure forecasts at both short and long horizons, with encouraging results. In particular, our forecasts are much more accurate at long horizons than various standard benchmark forecasts. Finally, we discuss a number of extensions, including generalized duration measures, applications to active bond portfolio management, and links between the term structure and macroeconomic fundamentals.