Dynamic term structure models: the best way to enforce the zero lower bound in the United States

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 25 September 2015

Working Paper No. 550
By Martin M Andreasen and Andrew Meldrum 

This paper studies whether dynamic term structure models for US nominal bond yields should enforce the zero lower bound by a quadratic policy rate or a shadow rate specification. We address the question by estimating quadratic term structure models (QTSMs) and shadow rate models (SRMs) with at most four pricing factors. Our findings suggest that QTSMs give a better in-sample fit than SRMs with two and three factors, whereas the SRM marginally dominates with four factors. Loadings from Campbell-Shiller regressions are generally better matched by the SRMs, which also outperform the QTSMs when forecasting bond yields, particularly with four pricing factors.

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