A New Perspective on Gaussian Dynamic Term Structure Models
Review of Financial Studies, Forthcoming
55 Pages Posted: 23 Mar 2009 Last revised: 13 Oct 2010
Date Written: October 12, 2010
In any canonical Gaussian dynamic term structure model (GDTSM), the conditional forecasts of the pricing factors are invariant to the imposition of no-arbitrage restrictions. This invariance is maintained even in the presence of a variety of restrictions on the factor structure of bond yields. To establish these results, we develop a novel canonical GDTSM in which the pricing factors are observable portfolios of yields. For our normalization, standard maximum likelihood algorithms converge to the global optimum almost instantaneously. We present empirical estimates and out-of-sample forecasts for several GDTSMs using data on U.S. Treasury bond yields. Taken together, our results shed new light on estimation and interpretation of GDTSMs, as well as the effects of different specifications of the risk premiums and the risk-neutral distribution of bond yields on the observed dynamics of the yield curve.
Keywords: dynamic term structure model, no-arbitrage, Gaussian, estimation
JEL Classification: E43, G12, C13
Suggested Citation: Suggested Citation