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How useful are no-arbitrage restrictions for forecasting the term structure of interest rates?

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  • Carriero, Andrea
  • Giacomini, Raffaella

Abstract

We develop a general framework for analyzing the usefulness of imposing parameter restrictions on a forecasting model. We propose a measure of the usefulness of the restrictions that depends on the forecaster's loss function and that could be time varying. We show how to conduct inference about this measure. The application of our methodology to analyzing the usefulness of no-arbitrage restrictions for forecasting the term structure of interest rates reveals that: (1)Â the restrictions have become less useful over time; (2)Â when using a statistical measure of accuracy, the restrictions are a useful way to reduce parameter estimation uncertainty, but are dominated by restrictions that do the same without using any theory; (3)Â when using an economic measure of accuracy, the no-arbitrage restrictions are no longer dominated by atheoretical restrictions, but for this to be true it is important that the restrictions incorporate a time-varying risk premium.

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  • Carriero, Andrea & Giacomini, Raffaella, 2011. "How useful are no-arbitrage restrictions for forecasting the term structure of interest rates?," Journal of Econometrics, Elsevier, vol. 164(1), pages 21-34, September.
    • Handle: RePEc:eee:econom:v:164:y:2011:i:1:p:21-34
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    More about this item

    Keywords

    Forecast combination Encompassing Loss functions Instability Affine term structure models;

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications

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