Specification Analysis of International Treasury Yield Curve Factors

• Activity Number: 83
• Type: Contributed
• Date/Time: Sunday, August 4, 2013 : 4:00 PM to 5:50 PM
• Sponsor: Business and Economic Statistics Section
• Author(s): Andrew Siegel*+ and Fulvio Pegoraro and Luca Tiozzo 'Pezzoli'
• Companies: University of Washington and Banque de France and Banque de France
• Keywords: common and local factors ; state-space model ; EM algorithm ; Kalman Filter ; Kalman Smoother

Abstract

We derive methodology to compute patterns of variation, over time and across countries, of the international term structure of interest rates, using maximum likelihood within a linear Gaussian state-space framework. Simultaneous estimation of common factors (across all countries) and local factors (specific to one country) requires a normalization procedure beyond ordinary factor analysis. By jointly estimating common and local factors we avoid sequential estimation effects that may explain the lack of agreement in the multi-country term structure literature regarding the number of factors and their nature. Yield curve data for U.S., Germany, U.K. and Japan, from January 1986 to December 2009, show that a model with correlated local factors only is generally preferred to a model of similar complexity that also includes one or more common factors (for which each common factor closely mimics a local factor from a pure local factor model). We reach the surprising conclusion that, while commonality exists as evidenced by strong correlation between local factors of different countries, there is no significant advantage to confining this common structure to its own factor(s).