Title

A Dynamic Model for the Forward Curve

Publication Type

Journal Article

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

Additional URL

http://dx.doi.org/10.1093/rfs/hhm039

Comments

Working paper available at http://ssrn.com/abstract=842204