Functional dynamic factor models with application to yield curve forecasting

Spencer Hays, Haipeng Shen, Jianhua Z. Huang

Research output: Contribution to journalArticlepeer-review

50 Scopus citations

Abstract

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.
Original languageEnglish (US)
Pages (from-to)870-894
Number of pages25
JournalThe Annals of Applied Statistics
Volume6
Issue number3
DOIs
StatePublished - Sep 2012
Externally publishedYes

Bibliographical note

KAUST Repository Item: Exported on 2020-10-01
Acknowledged KAUST grant number(s): KUS-C1-016-04
Acknowledgements: Supported in part NSF Grants DMS-06-06577, CMMI-0800575 and DMS-11-06912.Supported in part by NCI (CA57030), NSF (DMS-09-07170), and by Award No. KUS-C1-016-04, made by King Abdullah University of Science and Technology (KAUST).
This publication acknowledges KAUST support, but has no KAUST affiliated authors.

Fingerprint

Dive into the research topics of 'Functional dynamic factor models with application to yield curve forecasting'. Together they form a unique fingerprint.

Cite this