Shrinking the Term Structure

Damir Filipović, Markus Pelger and Ye Ye
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Damir Filipović: Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute
Ye Ye: Stanford University

No 22-61, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We introduce a conditional factor model for the term structure of treasury bonds, which unifies non-parametric curve estimation with cross-sectional asset pricing. Our robust, flexible and easy-to-implement method learns the discount bond excess return curve directly from observed returns of treasury securities. This curve lies in a reproducing kernel Hilbert space, which is derived from economic first principles, and optimally trades off smoothness against return fitting. We show that a low dimensional factor model arises because a sparse set of basis functions spans the estimated discount bond excess return curves. The estimated factors are investable portfolios of traded assets, which replicate the full term structure and are sufficient to hedge against interest rate changes. In an extensive empirical study on U.S. Treasuries, we show that the discount bond excess return curve is well explained by four factors, which capture polynomial shapes of increasing order and are necessary to explain the term structure premium. The cash flows of coupon bonds fully explain the factor exposure, and play the same role as firm characteristics in equity modeling. In this sense, “cash flows are covariances”. We introduce a new measure for the time-varying complexity of bond markets based on the exposure to higher-order factors, and show that changes in market complexity affects the term structure premium.

Keywords: Term structure of interest rates; bond returns; factor space; U.S. Treasury securities; non-parametric method; principal components; machine learning in finance; reproducing kernel Hilbert space (search for similar items in EconPapers)
JEL-codes: C14 C38 C55 G12 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2022-08
New Economics Papers: this item is included in nep-ifn
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Related works:
Working Paper: Shrinking the Term Structure (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2261

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