Predicting the Term Structure of Interest Rates: Incorporating Parameter Uncertainty, Model Uncertainty and Macroeconomic Information

Abstract

We forecast the term structure of U.S. Treasury zero-coupon bond yields by analyzing a range of models that have been used in the literature. We assess the relevance of parameter uncertainty by examining the added value of using Bayesian inference compared to frequentist estimation techniques, and model uncertainty by combining forecasts from individual models. Following current literature we also investigate the benefits of incorporating macroeconomic information in yield curve models. Our results show that adding macroeconomic factors is very beneficial for improving the out-of-sample forecasting performance of individual models. Despite this, the predictive accuracy of models varies over time considerably, irrespective of using the Bayesian or frequentist approach. We show that mitigating model uncertainty by combining forecasts leads to substantial gains in forecasting performance, especially when applying Bayesian model averaging.

Decision‐Based Forecast Evaluation of UK Interest Rate Predictability

“…Under these three portfolio combinations we consider how (i) the assumptions regarding predictability, (ii) whether the investor incorporates parameter uncertainty or not, (iii) her level of risk aversion and (iv) the length of the investment horizon, a¤ect the way in which she allocates her portfolio. 13 …”

Forecasting the Yield Curve in a Data-Rich Environment Using the Factor-Augmented Nelson-Siegel Model

“…However, a constant λ t can also be estimated along with the other model parameters using the Kalman filter, as in De Pooter et al (2007). Koopman et al (2010) propose ways of allowing for time-varying λ t .…”

“…These factors can, for example, be obtained by preselection of a subset of variables from x t , as in . Alternatively, the factors can be extracted from x t using principal component analysis as in De Pooter et al (2007). We describe alternative methods for constructing these factors below, in Sections 2.2-2.6.…”

Unspanned Macroeconomic Factors in the Yield Curve

“…The average level of the yield curve is usually associated with the inflation rate and the spread between long and short rates with temporary business cycles conditions; see Diebold, Rudebusch, and Aruoba (2006). For these reasons, macroeconomic information has been shown to help forecasting future interest rates and excess bond returns; see Ang and Piazzesi (2003), De Pooter, Ravazzolo, and Van Dijk (2007), Mönch (2008), Ludvigson andNg (2009), andFavero, Niu, andSala (2012).…”