Template-type: ReDIF-Paper 1.0
Author-Name: Clive G. Bowsher
Author-Email: clive.bowsher@nuffield.ox.ac.uk
Author-Workplace-Name: Nuffield College, Oxford University
Author-Name: Roland Meeks
Author-Email: roland.meeks@dal.frb.org
Author-Workplace-Name: Federal Reserve Bank of Dallas
Title: The Dynamics of Economic Functions: Modelling and Forecasting the Yield Curve
Abstract:  The class of Functional Signal plus Noise (FSN) models is introduced that provides a new, general 
method for modelling and forecasting time series of economic functions. The underlying, continuous economic 
function (or `signal') is a natural cubic spline whose dynamic evolution is driven by a cointegrated vector
autoregression for the ordinates (or 'y-values') at the knots of the spline. The natural cubic spline provides 
flexible cross-sectional fit and results in a linear, state space model. This FSN model achieves dimension 
reduction, provides a coherent description of the observed yield curve and its dynamics as the cross-sectional 
dimension N becomes large, and can feasibly be estimated and used for forecasting when N is large. The 
integration and cointegration properties of the model are derived. The FSN models are then applied to 
forecasting 36-dimensional yield curves for US Treasury bonds at the one month ahead horizon. The method 
consistently outperforms the Diebold and Li (2006) and random walk forecasts on the basis of both mean square 
forecast error criteria and economically relevant loss functions derived from the realised profits of pairs 
trading algorithms. The analysis also highlights in a concrete setting the dangers of attempts to infer the relative
economic value of model forecasts on the basis of their associated mean square forecast errors.
Keywords: FSN-ECM models, functional time series, term structure, forecasting interest rates, natural cubic
spline, state space form.
Classification-JEL: C33, C51, C53, E47, G12
Length: 40 pages
Creation-Date: 2008-27-04
Number: 2008-W05
File-URL: http://www.nuffield.ox.ac.uk/economics/papers/2008/w5/FSN.ECM_YCurve_Bowsher.pdf
File-Format: application/pdf
Handle: RePEc:nuf:econwp:0805