A0548
Title: Shrinking the term structure
Authors: Markus Pelger - Stanford University (United States) [presenting]
Damir Filipovic - EPFL and Swiss Finance Institute (Switzerland)
Ye Ye - Stanford (United States)
Abstract: A conditional factor model is developed for the term structure of Treasury bonds, which unifies non-parametric curve estimation with cross-sectional asset pricing. Factors are investable portfolios and estimated with cross-sectional ridge regressions. They correspond to the optimal non-parametric basis functions that span the discount curve and are based on economic first principles. Cash flows are covariances, which fully explain the factor exposure of coupon bonds. Empirically, it is shown that four factors explain the discount bond excess return curve and term structure premium, which depends on the market complexity measured by the time-varying importance of higher-order factors. The fourth term structure factor capturing complex shapes of the term structure premium is a hedge for bad economic times and pays off during recessions.
