The information in forward rates: Implications for models of the term structure

Unlike many developed countries in which zero interest rate policies are widely adopted, there is still room for interest rate fluctuations in China. Nevertheless, the dynamics of bond yields, forward rates and risk premia still differ from the traditional understanding. This paper focuses on the Chinese treasury bonds. By OLS regressions, we find movements in the current forward rate fully reflect future bond risk premia, while other variables do not improve its performances, regardless of in- and out-of-sample predictions. This result is confirmed by a group of no-arbitrage dynamic term structure models. Moreover, the theoretical models reveal three important findings: 1. there are about 20% predictable variations in annual excess returns; 2. only the level factor risk is priced; 3. the candidate macroeconomic variables cannot contribute to the term premia structure.

This paper studies the impact of time to build on the term structure of interest rates in an otherwise standard (Cox et al., 1985a; 1985b, CIR) production economy. Due to time to build, production depends not only on the current business condition as in the original CIR, but also on past conditions over the production period. This causes equilibrium quantities, including the short rate, forward rates, and bond returns, to depend on the historical path of the production opportunities. Production delay that accumulates uncertainty over the time to build generates significant time variations in bond risk premia. Bond returns can be predicted by current forward rates, as well as their lagged values, since current market states not only affect the current short rate but also the short rate in a distant future. Due to the path dependence, risk premia cannot be fully spanned by current yields. We show that time to build improves the ability of the CIR in generating empirical facts.

This paper studies the impact of time to build on the term structure of interest rates in an otherwise standard (Cox et al., 1985a; Cox et al., 1985b, CIR) production economy. Due to time to build, production depends not only on the current business condition as in the original CIR, but also on past conditions over the production period. This causes equilibrium quantities, including the short rate, forward rates, and bond returns, to depend on the historical path of the production opportunities. Production delay that accumulates uncertainty over the time to build generates significant time variations in bond risk premia. Bond returns can be predicted by current forward rates, as well as their lagged values, since current market states not only affect the current short rate but also the short rate in a distant future. Due to the path dependence, risk premia cannot be fully spanned by current yields. We find evidence that time to build improves the ability of the CIR in generating empirical facts.

Since the 2008 financial crisis, international interest rates have moved trivially over time, and have become less autocorrelated. Some previous empirical findings are thus no longer valid. This paper reexamines the changes in interest rate dynamics and the bond risk premia predictability for international markets. In contrast with previous studies, we document that the single forward rate displays statistically and economically significant in-sample and out-of-sample forecasting power on bond excess returns since the financial crisis. The good performance of the single forward rate means that forecasts tend to be more idiosyncratic, that is, most of variation in n-year expected excess return corresponds to n-year forward rate, rather than forward rates with other maturities. Calibrating an affine model suggests that the weak persistence of interest rates is driven by the underlying state variables that become less autocorrelated.

This study aims to examine return predictability in 24 emerging markets disaggregated in different regions. We propose four specifications, including a benchmark model. Then, an augmented model appropriate for each country, including a large set of potential factors, is evaluated. Furthermore, a dynamic multifactor model is investigated for all countries. Finally, we relax the symmetric hypothesis in asset return predictability based on a non-parametric non-linear approach: the projection pursuit regression model. Our study reveals three main findings. First, we reject all previous findings supporting a standard model of asset return predictability that is valuable for all countries, as we show that each country has specific domestic factors (both macroeconomic and financial) useful to predict future returns. Second, our empirical framework shows that asset return predictability might be robustly modelled based on non-linear specification based on the projection pursuit regression model. Our findings’ explanatory power of out-of-sample estimations is economically relevant. Our results are useful for investors and policy-makers for portfolio diversification and regulation policies.

Principal Component Analysis (PCA) is the most common nonparametric method for estimating the volatility structure of Gaussian interest rate models. One major difficulty in the estimation of these models is the fact that forward rate curves are not directly observable from the market so that non-trivial observational errors arise in any statistical analysis. In this work, we point out that the classical PCA analysis is not suitable for estimating factors of forward rate curves due to the presence of measurement errors induced by market microstructure effects and numerical interpolation. Our analysis indicates that the PCA based on the long-run covariance matrix is capable to extract the true covariance structure of the forward rate curves in the presence of observational errors. Moreover, it provides a significant reduction in the pricing errors due to noisy data typically found in forward rate curves.