An Error Correction Factor Model of Term Structure Slopes in International Swaps Markets

Pilar Abad and Alfonso Novales

Documentos de Trabajo del ICAE from Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico

Abstract: The first two principal components in the vector of term structure slopes from IRS markets in eight major currencies can be approximately identified as the slopes for the US dollar and Deutsche mark. Each of the eight slopes considered is cointegrated with these two factors. The implied Error Correction models can be very fruitful for short and medium term slope forecasting for the eight currencies. This scheme achieves a drastic reduction of dimensionality, since the eight slopes can be predicted using just univariate forecasts for the two factors. Adding more factors to the model does not lead to a significant improvement in forecasting performance, while forecasts obtained using just one factor are not as good as those from two-factor Error Correction models.

Keywords: Factor models; Term structure of interest rates; Principal components; Swap markets; IRS. (search for similar items in EconPapers)
JEL-codes: E37 E43 (search for similar items in EconPapers)
Pages: pages 19
Date: 2002
New Economics Papers: this item is included in nep-rmg
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