Forecasting the yield curve with the arbitrage-free dynamic Nelson–Siegel model: Brazilian evidence

Abstract

We assess the extent to which the imposition of a no-arbitrage restriction on the dynamic Nelson–Siegel model helps obtaining more accurate forecasts of the term structure. For that purpose, we provide an empirical application based on a large panel of Brazilian interest rate future contracts and test for differences in forecasting performance among alternative benchmark specifications including the random walk, vector autoregressions, and the dynamic Nelson–Siegel. We show empirically that the arbitrage-free Nelson–Siegel model is able to outperform all other benchmark models when longer forecasting horizons are taken into account.

Keywords

• Yield curve
• Arbitrage-free Nelson–Siegel model
• Dynamic factor models
• Kalman filter