Publication Type
Journal Article
Version
acceptedVersion
Publication Date
8-2010
Abstract
This article develops and estimates a dynamic arbitrage-free model of the current forward curve as the sum of (i) an unconditional component, (ii) a maturity-specific component and (iii) a date-specific component. The model combines features of the Preferred Habitat model, the Expectations Hypothesis (ET) and affine yield curve models; it permits a class of low-parameter, multiple state variable dynamic models for the forward curve. We show how to construct alternative parametric examples of the three components from a sum of exponential functions, verify that the resulting forward curves satisfy the Heath-Jarrow-Morton (HJM) conditions, and derive the risk-neutral dynamics for the purpose of pricing interest rate derivatives. We select a model from alternative affine examples that are fitted to the Fama-Bliss Treasury data over an initial training period and use it to generate out-of-sample forecasts for forward rates and yields. For forecast horizons of 6 months or longer, the forecasts of this model significantly outperform those from common benchmark models.
Discipline
Finance and Financial Management | Portfolio and Security Analysis
Research Areas
Finance
Publication
Review of Financial Studies
Volume
21
Issue
1
First Page
265
Last Page
310
ISSN
0893-9454
Identifier
10.1093/rfs/hhm039
Publisher
Oxford University Press
Citation
Chua, Choong Tze; Dean, Foster; Ramaswamy, Krishna; and Stine, Robert.
A dynamic model for the forward curve. (2010). Review of Financial Studies. 21, (1), 265-310.
Available at: https://ink.library.smu.edu.sg/lkcsb_research/2492
Copyright Owner and License
Authors
Creative Commons License
This work is licensed under a Creative Commons Attribution-NonCommercial-No Derivative Works 4.0 International License.
Additional URL
https://doi.org/10.1093/rfs/hhm039