Jointly written with Vahe Sahakyan (BIS) and Johannes Kramer (ECB)
A discrete-time no-dominance term structure model is developed. Four factors are modelled and explicitly defined to be: the short rate, the slope and curvature of the term structure of term-premia, and a measure that captures sovereign-specific features. We argue that these factors are directly useful for policy analysis and for investment professionals. An empirical application of the model is used to evaluate impacts on German and Italian yields of six ECB policy interventions from 2014 to 2020. We find that monetary policy actions during this period have compressed German yields by approximately 25, 85, and 125 basis points, at the 1Y, 5Y and 10Y maturities, respectively, and that these reductions exclusively result from changed to the term-premium component. In Italy the corresponding yield compressions are 55, 135, and 180 basis points, with the term premium component being responsible for approximately two-thirds of the action, while the remaining one-third stems from reductions in credit risk.
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.
A Practitioner's Guide to Discrete-Time Yield Curve Modelling (With Empirical Illustrations and MATLAB Examples)
The text is available as an Element on Cambridge University Press DOI: https://doi.org/10.1017/9781108975537
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 above link.
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Ken Nyholm (c) - Updated January 2022