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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Series ERIM Top-Core Articles
Journal Journal of Business and Economic Statistics
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