CFS Working Paper No. 2004/09
Forecasting the Term Structure
of Government Bond Yields *
Francis X. Diebold* and Canlin Li*
This Draft: October 14, 2003
Abstract:
Despite powerful advances in yield curve modeling in the last twenty years, comparatively
little attention has been paid to the key practical problem of forecasting the yield curve. In this
paper we do so. We use neither the no-arbitrage approach, which focuses on accurately fitting
the cross section of interest rates at any given time but neglects time-series dynamics, nor the
equilibrium approach, which focuses on time-series dynamics (primarily those of the
instantaneous rate) but pays comparatively little attention to fitting the entire cross section at
any given time and has been shown to forecast poorly. Instead, we use variations on the
Nelson-Siegel exponential components framework to model the entire yield curve, period-by-
period, as a three-dimensional parameter evolving dynamically. We show that the three time-
varying parameters may be interpreted as factors corresponding to level, slope and curvature,
and that they may be estimated with high efficiency. We propose and estimate autoregressive
models for the factors, and we show that our models are consistent with a variety of stylized
facts regarding the yield curve. We use our models to produce term-structure forecasts at both
short and long horizons, with encouraging results. In particular, our forecasts appear much
more accurate at long horizons than various standard benchmark forecasts.
JEL Code: G1, E4, C5
Key Words: Term structure, yield curve, factor model, Nelson-Siegel curve
Acknowledgments: The National Science Foundation, the Wharton Financial Institutions Center, and the
Guggenheim Foundation provided research support. For helpful comments we are grateful to the Editor (Arnold
Zellner), the Associate Editor, and three referees, as well as Dave Backus, Rob Bliss, Michael Brandt, Todd
Clark, Qiang Dai, Ron Gallant, Mike Gibbons, David Marshall, Monika Piazzesi, Eric Renault, Glenn
Rudebusch, Til Schuermann, and Stan Zin, and seminar participants at Geneva, Georgetown, Wharton, the
European Central Bank, and the National Bureau of Economic Research. We, however, bear full responsibility
for all remaining flaws.
Copyright © 2000-2003 F.X. Diebold and C. Li. This paper is available on the World Wide Web at
http://www.ssc.upenn.edu/~diebold and may be freely reproduced for educational and research purposes, so long
as it is not altered, this copyright notice is reproduced with it, and it is not sold for profit.
* University of Pennsylvania, and NBER, University of Pennsylvania and NBER, fdiebold@,wharton.upenn.edu
* University of California, Riverside