Modeling the time-varying dynamic term structure of interest rates

Ahjin Choi and Kyu Ho Kang

Journal of Banking & Finance, 2023, vol. 153, issue C

Abstract: We propose a new dynamic Nelson–Siegel yield curve model in which two time-varying factor-specific decay parameters govern the slope and curvature factor loadings, and the factor shock variance–covariance (SV) follows a stochastic inverse Wishart process. The proposed model is compared with simpler specifications in terms of statistical and economic criteria to demonstrate the importance of jointly incorporating time-varying factor loadings and SV. We examine the out-of-sample yield curve density forecasting performance for statistical evaluation. The utility gain from the bond portfolio optimization of a Bayesian risk-averse investor measures the model’s economic value. Our out-of-sample experiment using United States monthly yield curve data indicates that the time-varying factor loadings and SV accommodate gradual structural changes in the yield curve dynamics around an unconventional monetary policy period, thereby improving the predictive accuracy and utility gain.

Keywords: Out-of-sample density forecasting; Bond portfolio choice; Posterior predictive likelihood; Certainty equivalent return (search for similar items in EconPapers)
JEL-codes: C32 E43 E47 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:153:y:2023:i:c:s0378426623001206

DOI: 10.1016/j.jbankfin.2023.106908

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