I derive an arbitrage-free four-factor term structure model that facilitates direct parameterization of the short-term interest rate process. The interplay between macroeconomic variables and the term structure via a monetary policy reaction function, in the spirit of Taylor(1993), is therefore directly supported. I show that the proposed model is a constrained member of the canonical GDTSM family proposed by Joslin, Singleton and Zhu(2011). The model's loading structure bears close resemblance to that of the Svensson and Soderlind (1997) model, but it relies only on a single non-linear shape parameter, and the model is therefore easy to estimate. An empirical application to US data covering the period from 1961 to 2017 demonstrates that the proposed model fits yields well, and that an embedded policy rule, including industrial production and the inflation rate, is statistically significant and economically meaningful during this time-period.
I take a very practical approach and provide information on term stureture modelling and estimation techniques. I cover models that exclude arbitrage oportunities as well as ad-hoc approaches, Data and MATLAB codes used in the text can be downloaded from the MATLAB-section of my website.
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Ken Nyholm (c) - Updated August 2019