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Long-run Growth and Short-run Stabilization

Essays in Memory of Albert Ando

Edited by Lawrence R. Klein

There is much confusion in the economics literature on wage determination and the employment–inflation trade-off. Few model builders pay as much careful attention to the definition and meaning of long-run concepts as did Albert Ando. Expanding on years of painstaking work by Ando, the contributors elaborate on the main issues of economic analysis and policies that concerned him.
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Chapter 9: A Three-Factor Yield Curve Model: Non-Affine Structure, Systematic Risk Sources and Generalized Duration

Francis X. Diebold, Lei Ji and Canlin Li


9. A three-factor yield curve model: non-affine structure, systematic risk sources and generalized duration* Francis X. Diebold, Lei Ji and Canlin Li 1. INTRODUCTION We assess and apply the term-structure model introduced by Nelson and Siegel (1987) and re-interpreted by Diebold and Li (2005) as a modern three-factor model of level, slope and curvature. Our assessment and application has three components. First, we ask whether the model is a member of the recently popularized affine class, and we find that it is not. Hence the poor forecasting performance recently documented for affine termstructure models (e.g. Duffee, 2002) in no way implies that our model will forecast poorly, which is consistent with Diebold and Li’s (2005) finding that it indeed forecasts quite well. Second, having clarified the relationship between our three-factor model and the affine class, we proceed to assess its adequacy directly, by asking whether its level, slope and curvature factors capture systematic risk. We find that they do, and that they are therefore priced. In particular, we show that the cross-section of bond returns is well explained by the sensitivities (loadings) of the various bonds to the level, slope and curvature state variables (factors). Finally, confident in the ability of our three-factor model to capture the pricing relations present in the data, we proceed to explore its use for bond portfolio risk management. Traditional Macaulay duration is appropriate only in a one-factor (level) context; hence we move to a three-factor generalized duration...

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