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Term Structure Estimation with Survey Data on Interest Rate Forecasts

Published online by Cambridge University Press:  16 December 2011

Don H. Kim  and
Athanasios Orphanides
Don H. Kim
Affiliation:
School of Business, Yonsei University, 262 Seongsanno, Seodaemun-gu, Seoul 120-749, Korea, donhkim@yonsei.ac.kr
Athanasios Orphanides
Affiliation:
Central Bank of Cyprus, 80 Kennedy Ave., Nicosia 1076, Cyprus. athanasios.orphanides@centralbank.gov.cy
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Abstract

The estimation of dynamic no-arbitrage term structure models with a flexible specification of the market price of risk is beset by severe small-sample problems arising from the highly persistent nature of interest rates. We propose using survey forecasts of a short-term interest rate as an additional input to the estimation to overcome the problem. To illustrate the methodology, we estimate the 3-factor affine-Gaussian model with U.S. Treasury yields data and demonstrate that incorporating information from survey forecasts mitigates the small-sample problem. The model thus estimated for the 1990–2003 sample generates a stable and sensible estimate of the expected path of the short rate, reproduces the well-known stylized patterns in the expectations hypothesis tests, and captures some of the short-run variations in the survey forecast of the changes in longer-term interest rates.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 47 , Issue 1 , February 2012 , pp. 241 - 272
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2012

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