Empirical studies of the modern theories of bond pricing typically choose proxies for the state variables in a rather arbitrary fashion. This paper empirically analyzes the question of the optimal spot rates to use as state variables. The authors' findings indicate that the four-year spot rate serves as the best proxy in the one-state-variable model. In the case of the two-state-variables model, the six-year rate and eight-month rate are identified as best. Tests of the out-of-sample prediction ability indicate that their model is superior to F. R. Macaulay's duration model and alternative proxies for state variables.

ABSTRACT Empirical studies of the modern theories of bond pricing typically choose proxies for the state variables in a rather arbitrary fashion. This paper empirically analyzes the question of the optimal spot rates to use as state variables. Our findings indicate that the four‐year spot rate serves as the best proxy in the one‐state‐variable model. In the case of the two‐state‐variables model, the six‐year rate and eight‐month rate are identified as best. Tests of the out‐of‐sample prediction ability indicate that our model is superior to Macaulay's duration model and alternative proxies for state variables.