Thursday, May 14, 2015

Interesting New Work on Yield Curve Modeling

Loved last week's PIER lectures at Penn. Good people, good times, good spring weather.  (Please join us next year in May 2016! More information in due course.) On Thursday we did yield curves, which had me thinking about what's new that I like in that area. Not surprisingly, I'm a fan of dynamic Nelson-Siegel (DNS), arbitrage-Free Nelson-Siegel (AFNS), and the many variations.  (See the Diebold-Rudebusch 2013 book.) What's more surprising is that although Nelson-Siegel is almost thirty years old, and DNS/AFNS is almost a teenager, interesting and useful new variations keep coming along.

The most important new work concerns imposition of the zero lower bound (ZLB). Fischer Black's "shadow rate" approach has influenced me most. Recently it's been taken to new heights by Glenn Rudebusch and coauthors at the Federal Reserve Bank of San Francisco (e.g., Christensen and Rudebusch 2015 -- just published in Journal of Financial Econometrics), and Leo Krippner at the Reserve Bank of New Zealand (see his wonderful 2015 book). The amazing thing is that one can stay in the DNS/AFNS framework -- the key tractable subclass of Gaussian affine models -- and still respect the ZLB by appropriately truncating simple simulations. The figure below, assembled from some of Krippner's, says it all. Also see these slides.   

I'm also partial to shadow-rate ZLB work by Cynthia Wu and coauthors at Chicago and San Diego (e.g. Wu and Xia, 2014). (Thanks to Jim Hamilton, her Ph.D. advisor, for reminding me!) See the monthly Wu-Xia shadow short rate series, produced and published to the web by FRB Atlanta.

Last and not at all least is the recent "ARG0" work of Monfort et al., which imposes the ZLB in a very different and elegant way. Again see these slides.   

Another interesting strand of recent DNS/AFNS progress concerns modeling the interaction of bond yield factors, macro fundamentals, and central bank policy.  More on that sometime soon.