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Functional dynamic factor models with application to yield curve forecasting. (English) Zbl 1454.62302

Summary: Accurate forecasting of zero coupon bond yields for a continuum of maturities is paramount to bond portfolio management and derivative security pricing. Yet a universal model for yield curve forecasting has been elusive, and prior attempts often resulted in a trade-off between goodness of fit and consistency with economic theory. To address this, herein we propose a novel formulation which connects the dynamic factor model (DFM) framework with concepts from functional data analysis: a DFM with functional factor loading curves. This results in a model capable of forecasting functional time series. Further, in the yield curve context we show that the model retains economic interpretation. Model estimation is achieved through an expectation-maximization algorithm, where the time series parameters and factor loading curves are simultaneously estimated in a single step. Efficient computing is implemented and a data-driven smoothing parameter is nicely incorporated. We show that our model performs very well on forecasting actual yield data compared with existing approaches, especially in regard to profit-based assessment for an innovative trading exercise. We further illustrate the viability of our model to applications outside of yield forecasting.

MSC:

62P05 Applications of statistics to actuarial sciences and financial mathematics
62H25 Factor analysis and principal components; correspondence analysis
62R10 Functional data analysis
91G30 Interest rates, asset pricing, etc. (stochastic models)

Software:

forecast; fda (R)
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Full Text: DOI arXiv Euclid

References:

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