Staying on Top of the Curve: A Cascade Model of Term Structure Dynamics
2018, Journal of Financial and Quantitative Analysis, 53(2), pp.937-963
Abstract
This paper specifies term structure dynamics by a recursive cascade of heterogeneously persistent factors. The cascade naturally orders economic shocks by their adjustment speeds, and generates smooth interest-rate curves in closed form. For a class of specifications, the number of parameters is invariant to the size of the state space, and the term structure converges to a stochastic limit as the state dimension goes to infinity. High-dimensional specifications fit observed term structure almost perfectly, match the observed low correlation between movements in different maturities, and produce stable interest-rate forecasts that outperform lower-dimensional specifications.