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RFS Advance Access originally published online on October 16, 2007
Review of Financial Studies 2008 21(1):265-310; doi:10.1093/rfs/hhm039
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

A Dynamic Model for the Forward Curve

Choong Tze Chua
Singapore Management University

Dean Foster
University of Pennsylvania

Krishna Ramaswamy
University of Pennsylvania

Robert Stine
University of Pennsylvania

Address correspondence to Choong Tze Chua, Lee Kong Chian School of Business, Singapore Management University, 50 Stamford Road, Singapore 178899, or e-mail: ctchua{at}smu.edu.sg

JEL: C53, E43, E47


  Abstract

This article develops and estimates a dynamic arbitrage-free model of the current forward curve as the sum of (i) an unconditional component, (ii) a maturity-specific component and (iii) a date-specific component. The model combines features of the Preferred Habitat model, the Expectations Hypothesis (ET) and affine yield curve models; it permits a class of low-parameter, multiple state variable dynamic models for the forward curve. We show how to construct alternative parametric examples of the three components from a sum of exponential functions, verify that the resulting forward curves satisfy the Heath-Jarrow-Morton (HJM) conditions, and derive the risk-neutral dynamics for the purpose of pricing interest rate derivatives. We select a model from alternative affine examples that are fitted to the Fama-Bliss Treasury data over an initial training period and use it to generate out-of-sample forecasts for forward rates and yields. For forecast horizons of 6 months or longer, the forecasts of this model significantly outperform those from common benchmark models.

We would like to thank the editor, Yacine Aït-Sahalia, and two anonymous referees for their guidance. We are also grateful to Amir Yaron, Michael Brandt, Francis Diebold and seminar participants at The University of Pennsylvania, Singapore Management University, the 2005 Financial Management Association meeting in Siena and the 2005 Winter Research Conference at the Center for Analytical Finance, Indian School of Business in Hyderabad for their comments.


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