RESEARCH PROPOSAL

DYNAMICS OF THE TERM STRUCTURE OF INTEREST RATE AND MACROECONOMY

OBJECTIVES

 To study the dynamic interaction of the latent yield curve factors with macroeconomic variables in context of
Pakistan using Nelson Siegel Model.
INTRODUCTION TO BOND MARKET

 Bond is a tradable loan agreement.

 The issuer of bond promises the buyer or holder of the bond payments on prearranged schedule. Commonly,
bonds are issued by governments, financial institutes and corporations.
 The total outstanding value in world debt security (debt securities include bills, bonds, notes, etc.) market is
$20,443.4 billion.
 In Pakistan, total debt securities amount to $108 billion( Taken from Bank of International Settlement (BIS)
Quarterly Review of March 2018).
TERM STRUCTURE OF INTEREST RATE

 Two types of bonds

 Zero coupon bond (traded at discounted face value)
 Coupon bearing bond
 The relationship between the zero-coupon rates and maturities is known as the term structure of interest rate (yield
curve).
 Various shapes
 Shape: Significant for various economic and financial decisions
DEFINITIONS

 The discount function :

𝑃𝑡 (𝑚) = exp −𝑅𝑡 𝑚 𝑚
 Instantaneous forward rate:
𝑃𝑡′ 𝑚
𝑓𝑡 𝑚 = −
𝑃𝑡 𝑚
 Zero-coupon yield:
1 𝑚
𝑅𝑡 𝑚 = න 𝑓𝑡 𝑢 𝑑𝑢
𝑚 0
IMPORTANCE

 The yield curve contains information about the future path of the economy. Given that, yields on long maturity
bonds are expected values of average future short rates after adjustment for risk. Hence, yield spread assists in
forecasting future short rates and real activity in the economy.
 Also, a downward yield curve implies that investors expect near term inflation to be higher than long term.
 Moreover, inverted yield curves have followed US recessions.
 The information revealed by the term structure is used in discounting cashflows to present value
 In addition to that, researchers are interested in role of term structure in transmitting the signals of monetary
policy to the real sector, also how changes in monetary policy impact the short and long end of the yield curve.
CONCEPTUAL FRAMEWORK

 Economic theories regarding term structure of interest rates help explain why yield curve takes different shapes.
 A crucial aspect of economic theories of term structure is to explain empirical regularities of the yield curve, i.e.
slope or steepness of yield curve at different points in time.
 Why is the yield curve upward sloping, downward sloping, discontinuous, or continuous?
EXPECTATION THEORY

The Expectation hypothesis claims a close relationship between current interest rates or bond yields and expected
future interest rates
LIQUIDITY PREMIUM

 Liquidity Premium theory argues that expected returns on long term bonds should exceed the expected returns
on short term bonds to reward the investor for higher risk in form of higher price fluctuations.
 Liquidity premium exits because a given change in interest rates will impact prices of long term bonds more than
short term. A risk averse investor will require a higher yield to hold long term bond. This extra yield is called
liquidity premium. This theory depicts the slope of yield curve should be upward sloping.
MARKET SEGMENTATION

 There is little substitution between bonds of different maturities because investors have preferred habitats.
Investors will prefer to invest in bonds with maturity in certain interval, i.e. a maturity segment.
 For example, a pension fund with liabilities due in 30 years can reduce risk by investing in bonds that mature in 30
years.
 The theory suggests that separate market segments exist without any link between bond prices and yields in
different maturity segments. The yield curve will be discontinuous.
MODELS OF TERM STRUCTURE

 Vasicek model (1977)

 Cox, Ingersoll and Ross (1985)
 Nelson and Siegel (1987)
Vasicek (1977) developed a one-factor model of the term structure which depends on only one uncertainty factor, i.e.
the short rate.

𝑑𝑟𝑡 = 𝜅(𝜇 − 𝑟𝑡 )𝑑𝑡 + 𝜎𝑑𝑋𝑡

Cox, Ingersoll and Ross (1985) reformulated the Vasicek model as:

𝑑𝑟𝑡 = 𝜅(𝜇 − 𝑟𝑡 )𝑑𝑡 + 𝜎 𝑟𝑡 𝑑𝑋𝑡

 adopt a general equilibrium approach to endogenously determine the risk-free rate
 to prevent the short rate from becoming negative
The stochastic Properties of rt are as follows.
1. rt follows a square root diffusion that is almost surely non-negative.
2. the interest rate is elastically pulled towards a long term value μ> 0.
3. κ> 0 determines the speed of mean-reversion.
4. Feller condition: if 2κ𝜇 ≥ 𝜎 2 and rt > 0, then the process does not reach zero almost surely.
5. rt follows a non-central chi-square distribution.
DISTRIBUTION OF RISK-FREE RATE

𝑞
𝑣 2
𝑓CIR 𝑟𝑡𝑖 |𝑟𝑡𝑖−1 ; 𝜉, Δ𝑡 = 𝑐. 𝑒𝑥𝑝(−𝑢 − 𝑣) 𝐼𝑞 2 𝑢𝑣
𝑢
where ξ=(κ, μ, σ) is the parameter vector in (77),
2𝜅
𝑐=
𝜎 2 1 − 𝑒𝑥𝑝 −𝜅Δ𝑡
𝑢 = 𝑐𝑟𝑡𝑖−1 𝑒𝑥𝑝 −𝜅Δ𝑡
𝑣 = 𝑐𝑟𝑡𝑖
2𝜅𝜇
𝑞 = 2 −1
𝜎
and 𝐼𝑞 2 𝑟𝑡 is a modified Bessel function of the first kind of order q.

𝐸 𝑟𝑡𝑖 |𝑟𝑡𝑖−1 = 𝑟𝑡𝑖−1 𝑒𝑥𝑝 −𝜅Δ𝑡 +𝜅 1 − (𝑒𝑥𝑝 −𝜅Δ𝑡

𝜎2 𝜎2 2
𝑉𝑎𝑟 𝑟𝑡𝑖 |𝑟𝑡𝑖−1 = 𝑟𝑡𝑖−1 exp −𝜅Δ𝑡 − (𝑒𝑥𝑝(−2𝜅Δ𝑡 + 𝜇 1 − exp −𝜅Δ𝑡
𝜅 2𝜃
There exists a closed form solution for zero bond prices under affine term structure models and for the case of the CIR
model it is
𝑃t 𝑟𝑡 , 𝑚 = 𝐴𝑡 (𝑚)exp −𝐵𝑡 (𝑚) 𝑟𝑡
where m=T-t and
𝑚 2𝜅𝜇/𝜎 2
2𝜃. 𝑒𝑥𝑝 2 𝜃 + 𝜅
𝐴t 𝑚 =
2𝜃 + 𝜅 + 𝜃 𝑒𝑥𝑝 𝑚𝜃 − 1
2 𝑒𝑥𝑝 𝑚𝜃 − 1
𝐵t 𝑚 =
2𝜃 + 𝜅 + 𝜃 𝑒𝑥𝑝 𝑚𝜃 − 1
𝜃= 𝜅 2 + 2𝜎 2
Where we assume λ=0.
 To compute the term structure in the CIR model:

1
𝑅t 𝑚 = 𝐵𝑡 (𝑚)𝑟𝑡 − log (𝐴𝑡 (𝑚)
𝑚
YIELD CURVE SHAPES USING THE CIR MODEL
NELSON AND SIEGEL (1987)

 Nelson and Siegel (1987) propose that if spot rates are generated by a differential equation, then implied forward
rates will be the solutions to this equation.
 Assuming a second-order differential equation to describe the movements of the yield curve, [real and unequal
roots]

−𝑚 𝑚 −𝑚
𝑓t 𝑚 = 𝛽1𝑡 + 𝛽2𝑡 𝑒𝑥𝑝 + 𝛽3𝑡 𝑒𝑥𝑝
𝜏𝑡 𝜏𝑡 𝜏𝑡
 The solution for the yield as a function of maturity may be found by solving equation as in:

1 − 𝑒𝑥𝑝 −𝑚/𝜏𝑡 1 − 𝑒𝑥𝑝 −𝑚/𝜏𝑡 −𝑚

𝑅t 𝑚 = 𝛽1𝑡 + 𝛽2𝑡 + 𝛽3𝑡 − 𝑒𝑥𝑝
𝑚/𝜏𝑡 𝑚/𝜏𝑡 𝜏𝑡
 It can generate several shapes of the yield curve including upward, downward sloping and (inverse) hump shaped
with no more than one maxima or minima
YIELD CURVE SHAPES USING THE NELSON-
SIEGEL MODEL
 Moreover, the parameter vector, t= (β1t, β2t, β3t,τt), has economic interpretation. By focusing on the limiting path
of Rt(m), we can depict the parameter vector as level, slope, curvature, and shape parameter, respectively.
 𝑙𝑖𝑚 𝑅𝑡 𝑚 = 𝛽1𝑡 + 𝛽2𝑡
𝑚→0
𝑙𝑖𝑚 𝑅𝑡 𝑚 = 𝛽1𝑡
𝑚→∞

 β1t is the asymptotic value of the spot rate function, which is the long-term interest rate (level). Due to the
assumption of positive interest rates it is required that β1t > 0. β2t is the difference (spread).
YIELD CURVE AND MACROECONOMIC FACTORS

 The macroeconomic perspective of yield curve modelling, emphasizes on short rate as the key monetary policy
instrument
 the financial perspective also emphasizes on short rate since it is the building block for rates of other maturities
because long yields are risk adjusted averages of expected future short rates.
 Combining both perspectives, the macro-finance perspective, suggests that understanding how central bank
adjusts the policy rate in response to macroeconomic shocks will explains movement at the short end of the
yield curve.
 For monetary policy, forward rates are a useful indicator of market expectation of future interest rates, inflation
rates and exchange rates.
 Yield curve carries information about future GDP growth and path of the economy.
 Moreover, the movement in macroeconomic variables will have impact on the shape of the yield curve and short
rate.
 Monetary policy is a key aspect in movement of the yield curve.
 Yield Spread, defined as difference between the long rate and short rate, acts as an indicator for monetary policy
to forecast future economic activity and inflation in U.S economy.
 Referring to the slope factor from Nelson Siegel, 𝛽2𝑡 , carries information about the future inflation and provides
evidence that an inverted yield curve reflects expectations of a declining rate of real activity.
METHODOLOGY
 The Nelson-Siegel Model:

1 − exp −𝑚/𝜏𝑡 1 − exp −𝑚/𝜏𝑡 −𝑚

𝑅t 𝑚 = 𝛽1𝑡 + 𝛽2𝑡 + 𝛽3𝑡 − exp
𝑚/𝜏𝑡 𝑚/𝜏𝑡 𝜏𝑡

 Yields-Only Factors Model:

 In the state-space form the model can be written as,

𝑅𝑡 𝑚 = Λ 𝜏 𝛽𝑡 + 𝜀𝑡
𝜉𝑡 = 𝐴𝜉𝑡−1 + 𝜂𝑡
𝜀𝑡 0 Ω 0
𝜂𝑡 ∼ 𝑁 ,
0 0 Σ
 In measurement equation: 𝑅𝑡 𝑚 = 𝑅𝑡 (𝑚1 ) … … 𝑅𝑡 (𝑚𝑁 ) ′ , Λ(𝜏) and 𝜀𝑡
 In state equation: 𝜉𝑡 = 𝛽1𝑡 − 𝜇1 , 𝛽2𝑡 − 𝜇2 , 𝛽3𝑡 − 𝜇3 ′ .
 Σ: (3×3), assumed unrestricted (non-diagonal)
 Ω: (N×N), assumed to be diagonal.
 Three key macroeconomic variables:
 the annual growth rate in industrial production (LSMt , )

 real exchange rate (EXt) (PKR/$) and

 annual price inflation (INFt).

 Money Supply (MS_t )

 The model is:



𝑅𝑡 𝑚 Λ 𝜏 0 𝛽𝑡 𝜀𝑡
 = +
𝑍𝑡 0 𝐼4 𝑍ሚ𝑡 0
 𝜉𝑡 = 𝐴𝜉𝑡−1 + 𝜂𝑡
𝜀𝑡 0 Ω 0
 𝜂𝑡 ∼ 𝑁 ,
0 0 Σ

′
 ෪ 𝑡 −𝜇5 , 𝐼𝑁𝐹
𝜉𝑡 = 𝛽1𝑡 − 𝜇1 , 𝛽2𝑡 − 𝜇2 , 𝛽3𝑡 − 𝜇3 , 𝐿𝑆𝑀𝑡 −𝜇4 , 𝐸𝑋 ෪ 𝑡 − 𝜇7
෪ 𝑡 − 𝜇6 , 𝑀𝑆
′
 𝑍𝑡 = 𝐿𝑆𝑀𝑡 , 𝐸𝑋𝑡 , 𝐼𝑁𝐹𝑡 , 𝑀𝑆𝑡
 𝐴 is matrix of coefficients of interest (will shed light upon link between level, slope, curvature and macro factors)
and 𝜇 is vector of mean of factors.
DATA

 We will use monthly spot rates for zero-coupon bonds of Pakistan government bonds treasury bills. Concerning
macroeconomic variables, we will use monthly data for Large Scale Manufacturing (LSM), Money Supply (MS),
Consumer Price Index (INF), and $/PKR exchange rate (EX). The data will be obtained from State Bank of
Pakistan.
BIBLIOGRAPHY

 Cox, J. C., E Ingersoll, J., & Ross, S. (1985). A Theory of the Term Structure of Interest Rates. Econometrica, 53(2), 385–407. Retrieved from
https://econpapers.repec.org/RePEc:ecm:emetrp:v:53:y:1985:i:2:p:385-407
 Diebold, F. X., & Li, C. (2006). Forecasting the term structure of government bond yields. Journal of Econometrics, 130(2), 337–364.
 Diebold, F. X., Piazzesi, M., & Rudebusch, G. D. (2005). Modeling Bond Yields in Finance and Macroeconomics. The American Economic
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 Diebold, F., Rudebusch, G., & Aruoba, S. B. (2006). The macroeconomy and the yield curve: a dynamic latent factor approach. Journal of
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 Nelson, C., & Siegel, A. F. (1987). Parsimonious Modeling of Yield Curves. The Journal of Business, 60(4), 473–489. Retrieved from
https://econpapers.repec.org/RePEc:ucp:jnlbus:v:60:y:1987:i:4:p:473-89
 Ullah, W. (2016). Affine Term Structure Model with Macroeconomic Factors: Do No-Arbitrage Restriction and Macroeconomic Factors
Imply Better Out-of-Sample Forecasts? Journal of Forecasting, 35(4), 329–346. https://doi.org/10.1002/for.2378
 Ullah, W., Matsuda,Y., & Tsukuda,Y. (2014). Dynamics of the term structure of interest rates and monetary policy: is monetary policy
effective during zero interest rate policy? Journal of Applied Statistics, 41(3), 546–572. https://doi.org/10.1080/02664763.2013.845142
THANK YOU