Estimating the Yield Curve Using the Nelson-Siegel Model: A Ridge Regression Approach
44 Pages Posted: 8 May 2012 Last revised: 16 Feb 2015
Date Written: May 8, 2012
The Nelson-Siegel model is widely used in practice for fitting the term structure of interest rates. Due to the ease in linearizing the model, a grid search or an OLS approach using a fixed shape parameter are popular estimation procedures. The estimated parameters, however, have been reported (1) to behave erratically over time, and (2) to have relatively large variances. We show that the Nelson-Siegel model can become heavily collinear depending on the estimated/fixed shape parameter. A simple procedure based on ridge regression can remedy the reported problems significantly.
Keywords: Smoothed Bootstrap, Ridge Regression, Nelson-Siegel, Spot Rates
JEL Classification: E43, C51
Suggested Citation: Suggested Citation