Predictability of Interest Rates : An Analysis Using Dynamic Term Structure Models

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Existing dynamic term structure models have restrictions necessary for deriving bond prices in closed-form under non-arbitrage conditions, which, however, deteriorate the predictive power to the level and volatility of interest rates. This study removes such restrictions by relying on an accurate approximation method. By specifying the volatility as nonlinear functions of interest rate levels, the proposed models exhibit higher predictive power than the existing restrictive models. In addition, by combining the volatility forecast of the proposed models with that of time-series models such as GARCH, it is confirmed that the predictive power further increases.