The identification of the factors that determine the time-series and cross-section behaviour of the term structure of interest rates is a recurrent topic in the finance literature. Even though the interest rates for different maturities typically exhibit high correlations, these are far from being perfectly correlated. The main conclusion from the literature is that the yield curve is determined by different factors, usually described by its level, slope and curvature. Nevertheless, the identification of the yield curve factors is a controversial subject that has several empirical and practical implications, namely for the management of portfolios of fixed income securities, influencing the investment and hedging strategies within the context of portfolios of fixed income securities.

* This chapter is based on Cassola and Luis (2003) and on the PhD thesis of the second author (Luis, 2001).

Applied Quantitative Methods for Trading and Investment. Edited by C.L. Dunis, J. Laws and P. Nairn © 2003 John Wiley & Sons, Ltd ISBN: 0-470-84885-5

Moreover, a better knowledge of these factors would facilitate the task of risk managers, in particular for Value-at-Risk (VaR) purposes. In fact by simulating different paths for the factors the behaviour of the yield curve under different scenarios could be traced and alternative empirical distributions for interest rates could be retrieved (see e.g. Bolder (2001)). The analysis of the determining factors of the yield curve is also relevant for policy makers, namely in assessing the impact of monetary and fiscal policies (see, for instance, Fleming and Remolona (1998) and Bliss (1997)).

In this chapter, the German yield curve is analysed, given its relevance in the international bond markets and its informational content about future macroeconomic developments in one of the major European Union economies. Two databases are used in this chapter, the files "datgerse.txt" and "datgersb.txt", which are both included on the CD-Rom. The first database comprises monthly averages of nine daily spot rates for maturities of 1 and 3 months and 1, 2, 3, 4, 5, 7 and 10 years, between January 1986 and December 1998. The spot rates were estimated using the Nelson and Siegel (1987) and Svensson (1994) smoothing techniques from raw market data on euro-Deutschemark short-term interest rates and par yields of German government bonds.1 The smoothed estimates were used to construct one-period forward rates and perform forward rate regressions.2

As illustrated in Figure 3.1, the German end-month interest rates fluctuated markedly in the period from January 1986 to December 1998 (between 3% and 10%). These interest rate moves corresponded to significant shifts in the shape of the yield curve (Figure 3.2). In fact, during this period the yield curve moved from a flat pattern to a positively sloped curve. The sharp deceleration of the German economic growth between 1992 and 1993 was accompanied by a negatively sloped yield curve. Finally, at the end of the sample period, the yield curve returned to an almost null slope, achieving the lowest levels in the sample.

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