High Dimensional Yield Curves: Models and Forecasting

Nuffield Economics Discussion Paper

37 Pages Posted: 3 Oct 2006

See all articles by Clive G. Bowsher

Clive G. Bowsher

Statistical Laboratory, University of Cambridge

Roland Meeks

University of Oxford - Nuffield College

Date Written: October 2, 2006

Abstract

Functional Signal plus Noise (FSN) models are proposed for analysing the dynamics of a large cross-section of yields or asset prices in which contemporaneous observations are functionally related. The FSN models are used to forecast high dimensional yield curves for US Treasury bonds at the one month ahead horizon. The models achieve large reductions in mean square forecast errors relative to a random walk for yields and readily dominate both the Diebold and Li (2006) and random walk forecasts across all maturities studied. We show that the Expectations Theory (ET) of the term structure completely determines the conditional mean of any zero-coupon yield curve. This enables a novel evaluation of the ET in which its 1-step ahead forecasts are compared with those of rival methods such as the FSN models, with the results strongly supporting the growing body of empirical evidence against the ET. Yield spreads do provide important information for forecasting the yield curve, especially in the case of shorter maturities, but not in the manner prescribed by the Expectations Theory.

Keywords: yield curve, term structure, expectations theory, FSN models, functional time series, forecasting, state space form, cubic spline

JEL Classification: C33, C51, C53, E47, G12

Suggested Citation

Bowsher, Clive G. and Meeks, Roland, High Dimensional Yield Curves: Models and Forecasting (October 2, 2006). Nuffield Economics Discussion Paper, Available at SSRN: https://ssrn.com/abstract=934397 or http://dx.doi.org/10.2139/ssrn.934397

Clive G. Bowsher (Contact Author)

Statistical Laboratory, University of Cambridge ( email )

Wilberforce Road
Cambridge
United Kingdom

HOME PAGE: http://www.statslab.cam.ac.uk/~clive/

Roland Meeks

University of Oxford - Nuffield College ( email )

Manor Road Building
Manor Road
Oxford, OX1 3BJ
United Kingdom

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