Published online by Cambridge University Press: 09 March 2018
This paper specifies term structure dynamics by a recursive cascade of heterogeneously persistent factors. The cascade naturally orders economic shocks by their adjustment speeds, and generates smooth interest-rate curves in closed form. For a class of specifications, the number of parameters is invariant to the size of the state space, and the term structure converges to a stochastic limit as the state dimension goes to infinity. High-dimensional specifications fit observed term structure almost perfectly, match the observed low correlation between movements in different maturities, and produce stable interest-rate forecasts that outperform lower-dimensional specifications.
The authors thank David Backus, Hendrik Bessembinder (the editor), Tomas Björk, Peter Carr, Anna Cieslak, Antonio Diez de los Rios, Bjorn Flesaker, Mike Gallmeyer, Robert Goldstein (a referee), Jeremy Graveline, Dmitry Kreslavskiy, Markus Leippold, Vadim Linetsky, Andrei Lyashenko, Fabio Mercurio, Per Mykland, Andrew Siegel, Harvey Stein, David Weinbaum, Yildiray Yildirim, Hao Zhou, an anonymous referee, and seminar participants at Bloomberg, Cheung Kong Graduate School of Business, Columbia University, FGV/EBAPE, HEC Paris, Northwestern University, the Stockholm School of Economics, Syracuse University, the University of Chicago, the University of Minnesota, the University of Zürich, Ziff Brothers Investments, the 2010 Econometric Society World Congress, the 2010 Financial Econometrics Workshop at the Fields Institute in Toronto, the 2010 International Conference on Computing in Economics and Finance, the 2010 International Symposium on Business and Industrial Statistics, the 2010 McGill University Risk Management Conference, the 2010 Northern Finance Association conference, the 2010 Triple Crown Conference at Rutgers University, the 2011 Annual European Finance Association conference, and the 2011 Society of Financial Econometrics conference. Earlier versions of this paper circulated under the title “Dimension-Invariant Dynamic Term Structures.”