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No Arbitrage Priors, Drifting Volatilities, and the Term Structure of Interest Rates

Massimiliano Marcellino, Andrea Carriero and Todd Clark

No 9848, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We propose a method to produce density forecasts of the term structure of government bond yields that accounts for (i) the possible mispecification of an underlying Gaussian Affine Term Structure Model (GATSM) and (ii) the time varying volatility of interest rates. For this, we derive a Bayesian prior from a GATSM and use it to estimate the coefficients of a BVAR for the term structure, specifying a common, multiplicative, time varying volatility for the VAR disturbances. Results based on U.S. data show that this method significantly improves the precision of point and density forecasts of the term structure. While this paper focuses on term structure modelling, the proposed method can be applied for a wide range of alternative models, including DSGE models, and is a generalization of the method of Del Negro and Schorfheide (2004) to VARs featuring drifting volatilities. The method also generalizes the model of Giannone et al. (2012), by specifying hierarchically not only the prior variance but also the prior mean of the VAR coefficients. Our results show that both time variation in volatilities, and a hierarchical specification for the prior means, improve model fit and forecasting performance.

Keywords: Density forecasting; No arbitrage; stochastic volatility; Term structure (search for similar items in EconPapers)
JEL-codes: C32 C53 G17 (search for similar items in EconPapers)
Date: 2014-03
New Economics Papers: this item is included in nep-ecm and nep-for
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Related works:
Journal Article: No‐arbitrage priors, drifting volatilities, and the term structure of interest rates (2021) Downloads
Working Paper: No-Arbitrage Priors, Drifting Volatilities, and the Term Structure of Interest Rates (2020) Downloads
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