Faculty of Economics and Business Administration Publications Database

Forecasting the yield curve in a data-rich environment: A no-arbitrage factor-augmented VAR approach

Volume: 146
Number: 1
Pages: 26 - 43
Month: September
ISSN-Print: 0304-4076
Link External Source: Online Version
Year: 2008
Keywords: Yield curve; Factor-augmented VAR; Affine term structure models; Dynamic factor models; Forecasting

This paper suggests a term structure model which parsimoniously exploits a broad macroeconomic information set. The model uses the short rate and the common components of a large number of macroeconomic variables as factors. Precisely, the dynamics of the short rate are modeled with a Factor-Augmented Vector Autoregression and the term structure is derived using parameter restrictions implied by no-arbitrage. The model has economic appeal and provides better out-of-sample yield forecasts at intermediate and long horizons than a number of previously suggested approaches. The forecast improvement is highly significant and particularly pronounced for short and medium-term maturities.