An Empirical Analysis of the Curvature Factor of the Term Structure of Interest Rates



provided by Research Papers in Economics

An Empirical Analysis of the Curvature Factor
of the Term Structure of Interest Rates

Matteo Modena

University of Glasgow

Draft: September 2008

Abstract

This work extends the strand of literature that examines the relation between the term structure of interest
rates and macroeconomic variables. The yield curve is summarized by few latent factors (level, slope, and
curvature) which are obtained through Kalman filtering. In this paper, we address the challenging issue of
attributing an economic interpretation to the third unobservable component of the term structure, i.e.
curvature. In particular, we find significant evidence suggesting that curvature reflects the cyclical
fluctuations of the economy. Interestingly, this result holds in spite of whether the curvature factor is
extracted from the nominal or the real term structure. A negative shock to curvature seems either to
anticipate or to accompany a slowdown in economic activity. The curvature effect thus appears to
complement the transition from an upward sloping yield curve to a flat one. Finally, a joint macro-econometric
model for curvature and real activity is developed and estimated.

JEL Classification: C01, C32, E32, E44, G12

Keywords: Term Structure, Kalman Filtering, Latent Factors, Curvature, Business Cycle

Revised and published as:

A Macroeconomic Analysis of the Latent Factors of the Yield Curve: Curvature and
Real Activity

in

Gregoriou, G.N. and R. Pascalau (eds.) Financial Econometrics Modelling: Derivatives Pricing and
Hedge Funds and Term Structure Models
, Palgrave-MacMillan, 2011.

Abstract

This work extends the strand of literature that examines the relation between the term structure of interest
rates and macroeconomic variables. The yield curve is summarized by three latent factors which are
obtained through Kalman filtering the Nelson-Siegel term structure model. In this paper we address the
challenging issue of attributing a macroeconomic interpretation to the curvature factor finding evidence that
curvature reflects the cyclical fluctuations of the economy. Interestingly, this result holds in spite of whether
curvature is extracted from the nominal or the real term structure. A negative shock to curvature seems
either to anticipate or to accompany a slowdown in economic activity. The curvature effect thus complements
the transition from an upward sloping yield curve to a flat one.

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