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Title:Forecasting with the term structure: The role of no-arbitrage restrictions PDF Logo
Authors:Duffee, Gregory R.
Issue Date:2011
Series/Report no.:Working papers // the Johns Hopkins University, Department of Economics 576
Abstract:No-arbitrage term structure models impose cross-sectional restrictions among yields and can be used to impose dynamic restrictions on risk compensation. This paper evaluates the importance of these restrictions when using the term structure to forecast future bond yields. It concludes that no cross-sectional restrictions are helpful, because cross-sectional properties of yields are easy to infer with high precision. Dynamic restrictions are useful, but can be imposed without relying on the no-arbitrage structure. In practice, the most important dynamic restriction is that the first principal component of Treasury yields follows a random walk. A simple model built around this assumption produces out-of-sample forecasts that are more accurate than those of a variety of alternative dynamic models.
Document Type:Working Paper
Appears in Collections:Working Papers, Department of Economics, The Johns Hopkins University

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