Term structure modelling with observable state variables |
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Authors: | Cristian Huse |
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Affiliation: | Stockholm School of Economics, Department of Finance, PO Box 6501, SE-113 83 Stockholm, Sweden |
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Abstract: | This paper proposes and implements a parsimonious three-factor model of the term structure whose dynamics is driven uniquely by observable state variables. This approach allows comparing alternative views on the way state variables – macroeconomic variables, in particular – influence the yield curve dynamics, avoids curse of dimensionality problems, and provides more reliable inference by using both the cross-sectional and the time series dimension of the data. I simulate the small-sample properties of the procedure and conduct in- and out-of-sample studies using a comprehensive set of US data. I show that even a parsimonious model where the level, slope and curvature factors of the term structure are driven by, respectively, inflation, monetary policy and economic activity consistently outperforms the (latent-variable) benchmark model in an out-of-sample study. |
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Keywords: | JEL classification: C58 G12 G17 |
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