Forecasting the Yield curve in a Data-Rich Environment: A No-Arbitrage Factor-Augmented VAR Approach

This paper suggests a term structure model which parsimoniously exploits a broad macroeconomic information set. The model uses the short rate and the common components of a large number of macroeconomic variables as factors. Precisely, the dynamics of the short rate are modeled with a Factor-Augmented Vector Autoregression and the term structure is derived using parameter restrictions implied by no-arbitrage. The model has economic appeal and provides better out-of-sample yield forecasts than previously suggested approaches. The reduction of root mean squared forecast errors relative to the competitor models is highly significant and particularly pronounced for short and medium-term maturities.

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