Staff Working Paper No. 763
By Simon P Lloyd
No-arbitrage dynamic term structure models (DTSMs) have regularly been used to estimate interest rate expectations and term premia, but are beset by an identification problem that results in inaccurate estimates. I propose the augmentation of DTSMs with overnight indexed swap (OIS) rates to better estimate interest rate expectations and term premia along the whole term structure at daily frequencies. I illustrate this with a Gaussian affine DTSM augmented with 3 to 24-month OIS rates, which provide accurate information about interest rate expectations. The OIS-augmented model generates estimates of US interest rate expectations that closely correspond to those implied by federal funds futures rates and survey expectations out to a 10-year horizon, accurately depict their daily frequency evolution, and are more stable across samples. Against these metrics, interest rate expectation estimates, and therefore term premia, from OIS-augmented models are superior to estimates from existing Gaussian affine DTSMs.