On the Presence of News in a Hybrid Model of the Yield Curve

Abstract

This paper presents a 'hybrid' model of the yield curve that systematically incorporates the cross-equation restrictions of a structural dynamic stochastic general equilibrium model into an affine macro-factor model of interest rates. News, factors identified by interest rates that help to forecast future macroeconomic aggregates, are introduced into the modeling framework. Bayesian model comparison and classical likelihood ratio tests confirm the presence of news in the yield curve. Variance decompositions reveal that news shocks are responsible for a considerable amount of variation in yield curve factors. The Bayesian methodology provides a natural identification scheme for the various fundamental economic shocks and reveals the dimensions on which the structural model is misspecified. Interestingly estimated risk premia are found to vary much less over time when news shocks are included in the estimation.

Keywords: Yield, Curve, Term, Structure, DSGE, VAR, Affine, No-arbitrage

JEL Classification: C11, C13, C15, E10, E30, G12