Abstract
We develop estimation methodology for an additive nonparametric panel model that is suitable for capturing the pricing of coupon-paying government bonds followed over many time periods. We use our model to estimate the discount function and yield curve of nominally riskless government bonds. The novelty of our approach is the combination of two different techniques: cross-sectional nonparametric methods and kernel estimation for time varying dynamics in the time series context. The resulting estimator is used for predicting individual bond prices given the full schedule of their future payments. In addition, it is able to capture the yield curve shapes and dynamics commonly observed in the fixed income markets. We establish the consistency, the rate of convergence, and the asymptotic normality of the proposed estimator. A Monte Carlo exercise illustrates the good performance of the method under different scenarios. We apply our methodology to the daily CRSP bond market dataset, and compare ours with the popular Diebold and Li (2006) method.
Highlights
The yield curve, or the term structure of interest rates, describes how interest rates vary with maturity
The yield curve is instrumental in monetary policy decisions, because it serves as an indicator of the future interest rate level formed by current market expectations
We focus on the panel data framework that combines both cross-sectional and time series information
Summary
The yield curve, or the term structure of interest rates, describes how interest rates vary with maturity. There are two general approaches to estimating the yield curve at a point in time: parametric and nonparametric. The equilibrium approach derives the yield curve from the dynamic evolution of the time series of instantaneous spot rates and perhaps other state variables under the equilibrium condition. We develop new econometric methodology to estimate time varying yield curves nonparametrically from discrete time (daily) panel data on bond prices and cash flows; we provide the means to conduct inference about the yield curves.
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