The Central Tendency: A Second Factor in Bond Yields

Pierluigi Balduzzi; Sanjiv Ranjan Das; Silverio Foresi

doi:10.1162/003465398557339

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The Central Tendency: A Second Factor in Bond Yields

Pierluigi Balduzzi¹; Sanjiv Ranjan Das²; Silverio Foresi¹

¹ New York University · ² Harvard University Press

The Review of Economics and Statistics 1998

We assume that the instantaneous riskless rate reverts toward a central tendency which, in turn, is changing stochastically over time. As a result, current short-term rates are not sufficient to predict future short-term rate movements, as it would be the case if the central tendency were constant. However, since longer maturity bond prices incorporate information about the central tendency, longer maturity bond yields can be used to predict future short-term rate movements. We develop a two-factor model of the term structure which implies that a linear combination of any two rates can be used as a proxy for the central tendency. Based on this central-tendency proxy, we estimate a model of the one-month rate that performs better than models which assume the central tendency to be constant.

DOI: 10.1162/003465398557339
Volume: 80 (1)
Pages: 62-72
Language: en
Export: BibTeX
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