Yield curve modeling and forecasting using semiparametric factor dynamics

Using a Dynamic Semiparametric Factor Model (DSFM) we investigate the term structure of interest rates. The proposed methodology is applied to monthly interest rates for four southern European countries: Greece, Italy, Portugal and Spain from the introduction of the Euro to the recent European sovereign-debt crisis. Analyzing this extraordinary period, we compare our approach with the standard market method - dynamic Nelson-Siegel model. Our findings show that two nonparametric factors capture the spatial structure of the yield curve for each of the bond markets separately. We attributed both factors to the slope of the yield curve. For panel term structure data, three nonparametric factors are necessary to explain 95% variation. The estimated factor loadings are unit root processes and reveal high persistency. In comparison with the benchmark model, the DSFM technique shows superior short term forecasting.