In this article we introduce time-varying parameters in the dynamic Nelson-Siegel yield curve model for the simultaneous analysis and forecasting of interest rates of different maturities. The Nelson-Siegel model has been recently reformulated as a dynamic factor model with vector autoregressive factors. We extend this framework in two directions. First, the factor loadings in the Nelson-Siegel yield model depend on a single loading parameter that we treat as the fourth latent factor. Second, we specify the overall volatility as a generalized autoregressive conditional heteroscedasticity (GARCH) process. We present empirical evidence of considerable increases in within-sample goodness of fit for these advances in the dynamic Nelson-Siegel model.

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Keywords Extended Kalman filter, Generalized autoregressive conditional heteroscedasticity model, Time-varying volatility, Yield curve
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Koopman, S.J., Mallee, M.I.P., & van der Wel, M.. (2010). Analyzing the term structure of interest rates using the dynamic Nelson-Siegel model with time-varying parameters. Journal of Business and Economic Statistics, 28(3), 329–343. doi:10.1198/jbes.2009.07295