An Affine Model of Long Maturity Forward rates,

with Predictable Risk Premium

February 2003

Abstract
Distantly maturing forward rates represent the markets long term (risk neutral)
expectations about interest rates. As such, they are the fundamental ingredient
of the pricing kernel. In most equilibrium models, interest rates mean revert, and
long forward rates are asymptotically constant.
However, from US Treasury STRIPs data, forward rates slope increasingly
downwards, and do not attenuate in volatility, as maturity increases beyond about
15 years. We model this in a equilibrium framework, first showing that most of the
volatility in long forward rates is “short term”, coming from a predictable, tightly
mean reverting factor. We verify this predictable behavior in the STRIPs data,
and also in T Bond futures data. We also show that in principle, this predictability
can be exploited for profit in the T Bond futures market.
Our model also includes the notion that this predictability is not present, when
we transform to risk neutral probabilities. This is reasonable, since otherwise, the
market would move to obviate this predictability. Also, we are able to verify this
directly in the futures data, by identifying the risk neutral drift with the slope of
the futures term structure.
Our model falls into the Essential Affine class, but with predictable risk pre-
mium. It is striking that this short term behavior has such a large persistent effect
on the forward rates.

Introduction
Understanding the dynamics of long maturity interest rates is crucial to analyzing long
term investment strategies, and to issues of long term economic equilibrium. The longest
available default free rates (which in the US go out to about 30 years) therefore seems to
be a neglected area of study. This is perhaps because the long end of the term structure

1
might be assumed to be uninteresting: forward rates to borrow in say 20 years time will
not be influenced by events which are anticipated to be history within 20 years, and
would presumably just reflect long term inflation expectations. In fact most equilibrium
term structure models make the assumption that interest rates mean revert, and this
would seem necessarily to entail that long forward rates are just constant, on the basis
that a forward rates represents the (risk neutral) expectation of the spot1 rate when the
forward matures2 .3
In this paper we build and fit an equilibrium model for forward rates calculated from
US Treasury STRIPs prices. Specifically, we focus on the 6 forward rates for lending for
2 years, beginning at terms 13, 15, 17, 19, 21, 13 years, and we use weekly data, covering
the decade of the 1990s. We will first confirm for these rates, the basic stylized facts
for long forward rates, which have been previously documented by Brown and Schaefer
(2001): that these forward rates are not constant, and in fact are not much less volatile
than short interest rates, and their volatility does not attenuate as the maturity increases;
also these forward rates slope increasingly downwards, as maturity increases4 . Brown and
Schaefer note that these features have largely been overlooked by previous researchers,
though they seem to be well known to practitioners5 . These stylized facts stand as a
modelling challenge, particularly if we insist on the assumption that interest rates should
mean revert, in somewhat the same was as the well known evidence summarized in Duffee
(2002) and Dai and Singleton (2002), stands against the Expectations Hypothesis.
Key to our model, and to our resolution of the above challenge, is our finding that
our forward rates are predictable, on a time scale of a few weeks. For this result we use
the Variance Ratio statistic of Lo and MacKinlay (1988) to show that our forward rate
innovations are negatively autocorrelated, and we implement a Kalman filtering technique
proposed by Lo and Wang (1995), for extracting a predictable structure from negatively
1
We refer to ‘spot’ rates as contrasting with ‘forward’ rates, and ‘spot’ rate does not mean ‘instanta-
neous short rate’.
2
Biases to this expectation are introduced via convexity effects, and the risk premium. Crucial to
our model is an analysis of the dynamic structure of the risk premium.
3
Dybvig, Ingersoll and Ross (1996) show that if there are no arbitrage opportunities, then the asymp-
totically long forward rates cannot fall, and therefor must be constant, in any time homogeneous setting.
Their result does not need any assumptions about the risk premium.
4
Brown and Schaefer document these effects for a number of data series relating to US nominal bonds,
and to UK nominal and index linked bonds.
5
Suresh Krishnan, in a Merrill Lynch Publication “Introduction to the Treasury Strips market”
(1991), remarks that “...the 25 to 30 year sector [of the Strips market] suffers from the disadvantage of
riding up the yield curve.” Of course, this begs the question of why these bonds should continue to trade
at a ‘disadvantage’.

2
autocorrelated data. Our model thus has an extra “latent” state variable, which is not
autocorrelated, but to which the forward rate itself mean reverts, so that it is predictable.
In fact most of the volatility of the forward rate resides in the discrepancy between the
forward rate, and the latent component. We then argue that this predictability does not
carry over to the risk neutral dynamic, since otherwise the market would act to obviate
this predictability. We corroborate these surprising results by also documenting them
in the T Bond futures market; in this market we can in fact extract the risk neutral
dynamic directly, since, as we show, the risk neutral drift in any factor represented by a
futures price is equal to the slope of the futures price term structure. We also show that
we can in principle exploit this predictability for profit, in the T Bond futures market.
Finally, in our model, the risk neutral forward rate dynamic is allowed to be non-
mean reverting, even if the objectively realized dynamic is mean reverting, because the
predictable, tightly mean reverting aspect of the dynamic disappears, when we trans-
form to risk neutral probabilities. This allows us to resolve the challenge presented by
the stylized facts above, because the shape of the term structure is influenced by the
risk neutral dynamics, rather than the objective dynamics, of the state variables. This
resolution is similar to that of Duffee (2002) and Dai and Singleton (2002), to address
the failure of the Expectations Hypothesis, in that it revolves around a detailed analysis
of the risk premium.
Our model falls into the “essentially affine” analytic framework of Duffee (2002) and
Dai and Singleton (2002), in that the risk premium is dynamic, but the whole model con-
forms to the affine structure shown by Duffie and Kan (1996) to be very comprehensive,
but analytically tractable. In fact our has model has relatively an analytically trivial
Gaussian structure. However, our analysis is essentially distinct from theirs, relying on
the Lo and Wang filtering procedure for predictable innovations, and we will see that our
model is not merely an extrapolation of theirs into longer maturities, since they do not
capture the structure of our risk premium. We will show that our stylized features of long
forward rates can be captured by a single factor, Gaussian, essentially affine model, but
our model nests this, and is “more likely”, as well as reflecting the predictable behavior
of the forward rates. Moreover, this single factor model has some problems associated
with the possibility of negative interest rates, but our full model does not suffer from
these problems.
We now mention some previous papers dealing with long maturity interest rates.
Brown and Schaefer (2001), mentioned above, adopt a Gaussian modelling framework,
but they assume that there is (objectively) no mean reversion, and do not include any
special structure in the risk premium. Their first result is to show that their model

3
gives rise to the stylized facts mentioned above. They also note that in their model, the
degree of downward sloping is related to the volatility, and show that these are related
empirically. Prior to this paper, a number of authors, including Brown and Schaefer
(1994), who refer to Brown and Dybvig (1986), have noted that long maturity interest
rates seem “too volatile”. These papers, and also Jordan and Kuipers (1997), have
included very long rates, as well as short rates, in their fitted data. As in the present
paper, Jordan and Kuipers use STRIPs data. They compare the Vasicek and CIR models,
and the ‘Merton’ model, which is the Vasicek model without mean reversion. They are
not able to choose between the Vasicek and CIR Models, but they favor these over the
‘Merton’ model. However all these papers concentrate on yields of bonds, rather than
forward rates, and this prevents them from isolating the behavior of the long end.
The following is a plan of this paper, also mentioning some of the technical issues that
we deal with: In Section 1 we will introduce our STRIPs data, discuss the extraction
of the forward rates etc., and rehearse the stylized features that the our rates slope
increasingly downwards, and do not attenuate in volatility, as maturity increases.
In Section 2, we will present the preliminary ingredients of our model. First we
discuss the issue of mean reversion of interest rates, in general terms. We then fit the
single factor, Essential Vasicek Model (i.e. the Vasicek Model, with affine risk premium)
to our STRIPs forward rates, using the Kalman filter, to extract a single state variable,
which we refer to as the “filtered short rate”. This state variable could be identified with
the actual short rate, if our single factor Gaussian model were assumed to apply to the
entire term structure, but we emphasize that we are not making such an assumption;
rather we are assuming that a single Gaussian factor is sufficient for modelling our 6
long maturity forward rates. We adopt our “filtered short rate” formulation largely for
expositional convenience. The filtered short rate is also interesting in its own right,
however: if one works with a multifactor model, but assuming that a single, Gaussian
factor suffices for the long forward rates, then the filtered short rate can be identified as
the actual short rate, but with the transient components stripped away.
Next in this section, we do our Variance Ratio test on the single twelve year duration
forward rate, which is the average of our 6 two year rates, and we extract the predictable
component using the Lo and Wang procedure. Finally in this section, we present a non-
parametric estimation of the drift, volatility, and risk premium associated with this single
forward rate, following the procedure of Stanton (1997). This will be informal, and its
purpose will be to get an idea of any mis-specifications that our parametric modelling
might entail.
In Section 3 we will corroborate our predictability results, etc., for the STRIPs, by

4
showing that they also hold in the related but distinct T Bond futures market. In fact
the predictable component that we extract for the STRIPs and T Bond futures markets
are largely the same. We also present our argument that the risk neutral drift can be
identified with the slope of the futures term structure, and use this to characterize more
sharply the risk neutral dynamic. In this section, we also show how the predictability
can be exploited for profit, and finally we present a non-parametric estimation of the
objectively realized and risk neutral drift, risk premium, and volatility for the T Bond
futures market.
In Section 4 we present and fit our full model, which combines the Essential Vasicek
fit and the Lo and Wang extraction of the predictable component, from Section 2. We
also compare this model with some related models, particularly the model of Section 2.
Finally, in Section 5, we summarize our findings, and mention some associated direc-
tions for future research.

1 Our STRIPs Data and its Stylized Features

1.1 Our Data:
We will use weekly closing STRIPs prices, over the 10 year period from 01/01/906 to
12/31/99 (format MM/DD/YY), which includes 522 dates. This data has been down-
loaded from DataStream Ltd. The STRIPs7 programme was initiated by the US Federal
Reserve in 1983, allowing dealers to ‘strip’ a designated set of US Treasury bonds and
notes, which go out to term 30 years. ‘Stripping’ involves buying the Treasury bond,
and then separately selling the individual coupon and principal cash flows. These strips
are then registered, so that they become direct liabilities of the Treasury, and so are not
subject to the default risk of the dealer.
Strips are thus essentially pure discount bonds8 , and so they give the term structure
directly, without the necessity of estimating it from US Treasury coupon bonds. Also,
they are available on a six monthly cycle corresponding to the coupon cycle of the bonds
from which they are derived. Actually, there are two separate interlocking six monthly
6
Our data is weekly starting from this date. If any day is a holiday, then for this date we take data
for the next working day.
7
“Separate Trading of Registered Interest and Principal”
8
We will ignore taxation effects in this paper. However, these can have a significant effect on the
observed term structure. If the (before tax) term structure is flat at say r, and the effective (marginal)
tax rate is τ , then Livingston and Gregory (1989) show that the after tax term structure is flat at
(1 − τ )r. If the term structure is not flat, then taxation may introduce some small distortions.

5
cycles, corresponding to bonds which pay coupons in February and August, and bonds
which pay in May and October. We have presented results for the February-August cycle
only. Also, we have used Coupon Interest strips only, rather than Principal strips, since
these are available at all maturities, and do not inherit the idiosynchracies of the bonds
from which they are stripped9 .
It might be thought preferable if we had done the analysis of this paper starting from
US Treasury coupon bonds (and notes), and estimating the term structure of forward
rates from these, rather than using strips, since the coupon bonds are regarded as being
more liquid, and they are available with a much longer history. However, Bliss (1992)
and Zaretsky (1995) have noted that the strips term structure is just as good as the term
structure derived from the coupon bonds. Also, it is quite an unstable procedure to derive
the forward rates from an estimated term structure, because this is technically equivalent
to doing a numerical differentiation; see Steeley (1991). With regard to starting our data
at 1990, Brown and Schaefer (2001) note that the STRIPs data was quite noisy, in the
early years of the market’s existence.

1.2 Stylized features of the STRIPs forward curve and its volatil-
ity:
We work with the 6 continuously compounded forward rates (ft1 , ...ft6 ), derived from the
STRIPs, and with maturities 13, 15, 17, 19, 21, 23 years and each with duration 2 years.
t+13+2×(i−1)
In detail, the forward rate fti is given by 12 log tP t+13+2×i , where Ptq is the time t price of
P
t
the STRIP to mature at time q, and if no such STRIP exists, then we interpolate linearly
between the 2 adjacent STRIPs10 .
By ‘forward return’, we simply mean the proportional innovation in the forward price.
If we write the weekly time increment as δt, then we take the ith forward return dfti over
t+13+2×(i−1) t+13+2×(i−1)
1 Pt+δt
− 12 log
Pt
the week [t, t + δt] to be 2
log t+13+2×i
Pt+δt Ptt+13+2×i
. In terms of the forward

9
The distinction is that the coupon/principal strip is derived from the coupon/principal part of the
bond which is stripped; the Fed allows the coupon bonds to be ‘reconned’ from the strips, but a principal/
coupon strip must be used to make up the coupon/principal part of the bond being reconned. Since
only one bond is designated as strippable at each maturity, this means that when reconning the bond,
the principal strip which came from that particular bond must be used. But any coupon strips may be
used with the appropriate maturities, and so a coupon strip is not associated with any particular coupon
bond.
10
Thus, we need STRIPs prices for terms up to about 25.5 years, and this is as far as the STRIPs
data in DataStream will allow.

6
 [s,q]
[s,q] Pts 1 Ft+δt
prices Ft := Ptq
, it is easy to see that our forward returns are given by 2
log [s,q] , with
Ft
s = t + 13 + 2 × (i − 1), q = t + 13 + 2 × i, which is the return of the forward price,
with continuous compounding. Note that each of the two forward prices involved in the
forward return here refers to the same (interpolated) pair of STRIPs bonds.
Figure 1 is a 3 dimensional graph of the STRIPs forward rate term structures, at our
historical dates. This clearly shows the decline at the long end of the term structure.
Table 1 gives the time series averages of each of the forward rates, which again shows
their declining shape, and it gives their (arithmetic) volatilities, which do not attenuate
as maturity increases. Figure 2, Panel B gives the time series of our 13 and 13 year
forward rates, i.e. ft1 and ft6 . This clearly shows athe downward slope, in that ft6 is
always lower than ft1 .
Table 1 also includes a Principal Components Analysis (PCA) of the volatility struc-
ture of the STRIPs forward rates. PCA is a convenient way to get an idea of the
ways in which the term structure can move, and this procedure has also been ap-
plied to the term structure of volatility by Dybvig (1988) and Steeley (1991), and is
explained by Rao (1973). Our PCA starts from the covariance matrix of our forward re-
√ √ √
turns. The Principal Components are then the factors µ1 E1 , µ2 E2 , ..., µq Eq , where
µ1 ≥ µ2 ≥ ... ≥ µn ≥ 0 are the eigenvalues and E1 , E2 , ..., En is the corresponding
orthonormal basis of eigenvectors of this matrix. The most efficient way to represent
the term structure evolution in terms of say q sources of randomness is via the first q
µi
Principal Components. Also, the ith component accounts for a proportion µ1 +...+µ n
of
the variation represented by the full covariance matrix.
The PCAs in Table 1, indicate that 57% of the movements of our forward rates is
accounted for by the first component, which is basically a vector of constant volatilities
of about 0.8%. This means that the principal aspect in which the forward rates move,
is parallel shift with (annualized) volatility of 0.8%. The other components look quite
unstructured, suggesting that they represent unstructured noise.

2 Preliminary Modelling Ingredients

2.1 Some remarks on mean reversion of interest rates:
The model of this paper will allow (the market to expect) the forward rate to be mean
reverting in the objective probability, even though it is not in the risk neutral probability.
It will be useful to discuss here, in general terms, the issue of mean reversion of interest

7
rates.
First, mean reversion is theoretically desirable, and usually assumed in theoretical
models, since without it, interest rates would become unbounded. It is also usually
desirable that an econometric model fit should indicate stationarity, since otherwise the
asymptotic large sample inference might be suspect. It is surprisingly difficult, however,
to establish statistically that interest rates actually do mean revert.
Addressing this issue, Wu and Zhang (1996) take interest rate series from 12 OECD
countries, with monthly data from January 1974 to September 1994, and they confirm
that for each one taken individually, they cannot reject a unit root hypothesis. However,
taking the series together, and assuming that the autoregressive coefficient is the same for
each, they are able to reject the unit root. Dai and Singleton’s essentially affine A0C (3)
Model (which they favor) also indicates mean reversion, using monthly US data from
1970 - 1995.
Our estimations below only use 10 years of weekly data, and they are not able to
reject the unit root hypothesis, in favor of mean reversion. We thus present them with
the estimated value of the mean reversion parameter κ, and then with κ set at 0.125, and
then note that our conclusions are not significantly affected by this change. Freezing κ at
0.125 has the advantage of making the model stationary, and this also seems a reasonable
magnitude: the long forward rate over the period 1970 - 2000 has a standard deviation of
about 2%11 , and if we take this to be the unconditional standard deviation σU , and take
the annual volatility σ to be 1%, then this corresponds to a mean reversion parameter of
0.125, if we assume that the forward rate follows an OU process12 .

2.2 Fitting the Essential Vasicek Model to long forward rates:

The Vasicek (1977) Model is the simplest non-trivial model for the term structure of
interest rates. In this model, the short rate rt is usually taken to be the state variable,
obeying the Ito Equation
drt = κ(r̄ − rt )dt + σdWt , (1)
in which dWt is the increment of standard Brownian Motion; also the mean short rate r̄,
volatility σ, and speed of reversion to the mean κ, are all constants. In its original “plain
vanilla” form, the risk premium λ is assumed to be constant, but we will use the extended
formulation with λt = λ0 + λ1 rt , and refer to this as the Essential Vasicek Model. Duffee
11
To arrive at this figure, we calculated the forward rate to borrow in 15 year’s time, for 10 years,
from the monthly Fama-Bliss files of estimated zero coupon rates. √
12
See Karatzas and Shreve, page 358, who show that σu = σ/ 2κ.

8
(2002), and Dai and Singleton (2002), have implemented similar extensions to the risk
premium for general affine models, referring to them as Essentially Affine Models, and
noting that such extensions do not break the affine structure of the model. In terms
of the instantaneous forward rate ftq at time t and with maturity q, which is defined in
terms of pure discount bond prices Ptq by ftq = − ∂q
∂
log Ptq , the solution to this Essential
Vasicek model can be written

 1
ftq = rt + (R̄ − αrt ) B(q − t) − σ 2 B(q − t)2 , (2)
2
in which α = κ − λ1 σ (the “risk neutral” mean reversion), R̄ = κr̄ + λ0 σ, and B(τ ) =
1
α
(1 − e−ατ ) if α = 0, and B(τ ) = τ , if α = 0. We will use the variables R̄ and α, rather
than λ0 , λ1 , in our econometric fit, to mitigate collinearity problems.
From Equation (2) it is easy to see that the forward rate has an inverted quadratic
structure, if α = 0. The (geometric) volatility of the pure discount bond price Ptq is given
by σB(q − t) in the model, and the (arithmetic) volatility of the instantaneous forward
rate is given by σe−α(q−t) . The non-attenuating forward rate volatility thus also follows
if α = 0. This extended version of the Vasicek Model can thus in principle accommodate
the stylized facts of Section 1, if we allow the risk premium to be state dependent, but
in the original form of the Vasicek Model, these stylized facts seem not to be consistent
with mean reversion of interest rates.
We will fit this model to our long forward rates, via the Kalman filter, which is
explained in Hamilton (1994). The Kalman filter applies to linear models, and allows
us to infer the time series of an unobserved state variable (the “signal”), from a related
“observation”. It can also be used to estimate the parameters of the model from the
observed data. We will take the signal to be a “filtered” version of the short rate as in
Equation (1) and the observation to be the vector of forward rates (ft1 , ...ft6 ) described
in Section 1 above.
This choice of the “filtered short rate” as the signal state variable might seem strange,
since we are modelling long maturity forward rates, which are not affected by short term
phenomena. We do this mainly for the sake of convenience, and we do not claim that our
“filtered short rate” should agree with the actual short rate. We could have taken one of
our forward rates to be the state variable, and this would have made it unnecessary to
use the Kalman filter. The advantage of using the Kalman filter is that all our forward
rates, together with their error structure, can be treated on an equal footing. When we
present our final model in Section 4, we will graph the filtered short rate and the actual
short rate (see Figure 10), and discuss the relationship between these.

9
 For our fit, we must first adapt Equation (1) to take account of the weekly (non-
infinitesimal) time step, denoted by ∆t, so that it becomes

rt+1 = e−κ∆t rt + r̄(1 − e−κ∆t ) + wt , (3)

∆t 
where wt is normally distributed with mean zero and variance σ 2 s=0 (e−κs )2 ds and the
wt ’s are independent for different values of t. Also, we must adapt Equation (2) to take
account of the fact that the observations are not instantaneous forward rates, but have
duration 2 years, and to include a model error, so that it becomes
1
  s=t+13+2×(i) 1 2  s=t+13+2×(i)
fti = rt + R̄ − αrt B(s)ds − σ B(s)2 ds + rti , (4)
2 s=t+13+2×(i−1) 4 s=t+13+2×(i−1)

where rti is normally distributed with mean zero and variance which we parameterize as
exp{−2i } and the rti ’s are independent for different values of i and t. In Hamilton’s
nomenclature, Equation (3) is the “state equation”, and Equation (4) is the “observation
equation”.
The fitted Vasicek parameters are given in Table 2. This table gives 4 fits; with and
without freezing κ at 0.125, and with and without the plain vanilla Vasicek constraint
κ = α. The salient result from this table is that the “risk neutral” mean reversion
parameter α is close to zero (in fact it is slightly negative), so that Essential Vasicek
Model can be reconciled with objective mean reversion, only if the risk premium is
allowed to vary with the “filtered short rate”. We also see that the objective mean
reversion parameter κ is not significantly different from zero, in the extended model, and
freezing κ at 0.125 does not significantly affect the other estimates. But κ(≡ α) is close
to zero in the plain vanilla model, and freezing it at 0.125 greatly reduces the likelihood
of the model.
The fitting exercise of this Subsection thus favors the Essential Vasicek Model, but
with the feature that the state variable is not mean reverting, in the risk neutral proba-
bility. This feature is not theoretically problematic, so long at the state variable is mean
reverting in the objective probability.
However, this model does have a problem with our long forward rates, in allowing
interest rates to become negative. Negative interest rates theoretically entail arbitrage
opportunities, and if this is precluded in the objective probability, then it must also be
precluded in the risk neutral measure. In the Extended Vasicek Model with mean rever-
sion, there is a small objective probability that the interest rate can become negative.
This is generally regarded as an innocuous fault in the Vasicek Model, since this proba-
bility is small. But for α = 0, this translates to a substantial risk neutral probability that

10
the rate can become negative, before the maturity of the forward rates we are considering.
This has a significant effect on the model forward rates.
To preclude the possibility of negative interest rates in the Extended Vasicek Model,
we solved it via the PDE approach, imposing α = 0, and a reflecting boundary con-
dition at zero, imposed on the (filtered) short rate. This is the mildest way to avoid
negative rates. The result is presented in Fig 2, Panel A, with and without this bound-
ary condition, and with the model parameters from the first column of Table 2. This
panel gives the calculated instantaneous forward rate term structures, corresponding to
(filtered) short rates r = 0%, 2%, 4%, 6%, 8%. With the barrier, there is a lower bound
on the forward rates, corresponding to r = 0%, which increases with maturity. In fact
for forward rates below about 5%, the term structure does not slope downwards, and
the curves get closer together, indicating that the volatility does attenuate, as maturity
increases. These effects arise because precluding negative interest rates forces the forward
rates higher. But from Figure 2, Panel B, we see that these features are not reflected in
the data. This panel gives the time series of our 13 year and 23 year forward rates, i.e.
ft1 , ft6 , and clearly the slope ft6 − ft1 does not change to being positive, as ft6 decreases
below 5%.
Our model of Section 4, with predictability, will not be subject to this criticism, since
in that model, negative interest rates can be precluded without significantly affecting the
long forward rates.

2.3 Modelling predictability in the STRIPs long forward rates:

In this subsection we will mostly work with the continuously compounded forward rate
with maturity 13 years and duration 12 years. This is the arithmetic average of the
6 forward rate factors with 2 year durations, that we have modelled above. We will
continue to work with the weekly data for the decade 01/01/90 - 12/31/99.
We first present the results of applying the Variance Ratio test Lo and MacKinlay
(1988), for autocorrelation of the STRIPs forward returns. Lo and MacKinlay develop
their test for non-dividend paying stocks, for which the return is just the first difference
of the log-price. Their test simply compares the variance of the of returns, estimated
using a given time step, with the same variance estimated over double (or 3 times...)
the time step. If there is no autocorrelation, then the variance should simply double (or
treble...). The ratio of these variances is actually robust to heteroskedasticity, i.e. to the
variance itself being allowed to vary, and Lo and MacKinlay present a correspondingly
robust test of the significance of the autocorrelation.

11
 Table 3 gives results of the Variance Ratio tests for the 2 year duration forward
rates, and the 12 year duration forward rate, which is the average of these. This is
rather inconclusive as evidence for predictability of the 12 year duration rate. (The
corresponding test using the T Bond futures will be more conclusive.)
We will now implement the procedure proposed by Lo and Wang (1995), to model
predictability of the 12 year duration forward rate series, which we will denote in this
subsection by ft . The procedure is to posit a second state variable Xt , to which ft mean
reverts, via the equations

dft = δ(Xt − ft )dt + σ f dWtf , (5)

dXt = κ(X̄ − Xt )dt + σ X dWtX . (6)

If δ > 0, then ft is predictable, in that it reverts to Xt . We will assume for simplicity that
the Brownian increments dWtf and dWtX in Equations (5) and (6) here are not correlated.
As in the previous subsection, we must first discretize the system to take account of
the weekly (non-infinitesimal) time step. The system then becomes

ft+1 = af ft + φf,X Xt + q f + ft , (7)

Xt+1 = aX Xt + q X + X
t , (8)
X̄δ ∆t 
in which af = e−δ∆t , aX = e−κ∆t , φf,X = δ−κ
δ
(e−δ∆t − e−κ∆t ), q f = κδ−κ s=0 (e
−δ∆t
−
−κ∆t
 ∆t −κs 
f ∆t −δs X  ∆t −κs −δs
e )ds, f = κX̄ s=0 e ds, t = σ s=0 e dWs + (δ−κ) s=0 (e − e )dWs , t =
X f f σ δ X X

∆t −κs
σ X s=0 e sWtX . Thus (ft , X
t ) are jointly normally distributed, and their covariance
matrix is
  ∆t  2  
f 2 −2δs σX δ ∆t −κs −δs 2 (σ X )2 δ  ∆t −κs −κs −δs

(σ ) s=0 e ds + δ−κ s=0 (e −e ) ds , δ−κ s=0 e (e −e )ds 
(σ X )2 δ  ∆t −κs −κs −δs

X 2 ∆t −2κs
δ−κ s=0 e (e −e )ds , (σ ) s=0 e ds
 
(σ f )2 (∆t − δ(∆t)2 , 12 (σ X )2 δ(∆t)2
= 1 + o(∆t)2 (9)
2
(σ X )2 δ(∆t)2 , (σ X )2 (∆t − κ(∆t)2
In our Kalman filtering implementation, we take the signal to be (ft , Xt ), and the “state
equation” to be (7) and (8) taken together. Also, we take the observation to be ft , so
that the “observation equation” is trivial, and there is no model (“observation”) error.
Maximum likelihood estimates of the parameters and their standard errors, are given
in Table 4, and the graphs of ft , Xt , and the residual Xt − ft are given in Figure 3. Since
σ f and δ are highly collinear (in the sense that the associated partial derivatives of the

12
log-likelihoods at each time, i.e. the scores, are
√ highly correlated), we have replaced δ
f
in the Maximum Likelihood Estimation by σ / 2δ, which is the unconditional standard
deviation of ft according to Equation (5), if we ignore the effect of Xt . This change of
variables
√ was necessary to make the procedure converge. We see via the t-statistic on
f
σ / 2δ, that the mean reverting behavior of the innovations is highly significant, and
the parameter estimate δ = 26.35 indicates that the time scale for the mean reversion
is a matter of weeks. The mean reversion parameter κ, corresponding to X, is not
significantly different from zero, but freezing it at 0.125 does not significantly affect the
other estimates.
Table 5 presents the result of the Variance Ratio Test applied to the time series Xt ,
ft and Xt − ft . We see that there is little negative autocorrelation left in Xt , and it has
mostly been accounted for in Xt − ft .

2.4 Kernel density estimation of the STRIPs forward rate dy-

namics:
Here we will implement a kernel density estimation of the dynamics and risk premium
of our STRIPs long forward rates, following Stanton (1997). Our aim is to gain further
insight into the suitability of the Essential Vasicek Model for this data, and also to
reinforce a similar exercise that we will present below for the T Bond Futures data.
Kernel density estimation is a non-parametric procedure, and thus has the advantage
that it does not pre-suppose any functional form for the dynamics. On the other hand,
the inferences that can be drawn from it tend to be quite weak, and recent work by
Chapman and Pearson (2000) points to biases when the procedure is used to study the
dynamic at extreme interest rates. However, our implementation will be quite informal,
and we will not attempt to calculate confidence intervals. In fact the predictability that
we have documented, entails that this kernel density procedure is mis-specified, and so
we can only use it here for obtaining indicative results.
Our implementation is briefly described as follows: First, we assume that the forward
rate series is Markovian, so that we can write

dft = ξ(ft )dt + η(ft )dWt . (10)

Then the drift ξ(f ) in Equation (10) at any value ft , gives the expectation of ft+1 − ft at
any time t for which ft = f . The procedure for estimating ξ(f ) for each f , is essentially
just to take the average of all historical values ft+1 − ft for which ft = f . To estimate
the volatility (squared), we replace the forward rate increment ft+1 − ft by its square. Of

13
course, as stated, this procedure would not give an answer, because the discreteness of the
data means that the realized rates ft are never likely to coincide with f ; to overcome this,
a Kernel Density is used. This is a function K(x) which charges a region close to zero,
1 1 2
but which is very small elsewhere. Stanton uses the normal density K(x) = (2π)− 2 e− 2 x .
The estimate ξ(f ) is actually taken to be average over all values ft+1 − ft , but weighted
according to the value K((ft − f )/h), where h is a chosen ‘bandwidth’. The weight is
thus higher if ft is nearer to f , and the distance is normalized by h. We will work with
Stanton’s kernel function, and with h = 1%.
To estimate the “total” risk premium,
we replace the forward rate increment by the 
1
simply compounded forward return, i.e. 12 t+25
(Pt+1 − Ptt+25 )/Ptt+25 − (Pt+1
t+13
− Ptt+13 )/Ptt+13 .
This is the cash flow at time t+ 1, obtained from buying 12×P1 t+25 of the STRIP with term
t
to maturity 25 years, and selling 12×P1 t+13 of the STRIP with term to maturity 13 years,
t
and then liquidating this position at time t + 1. Since this strategy does not involve any
cash flow at time t, its expected payoff under risk neutral probabilities is zero, and so
any payoff consistently biased away from zero, must represent the risk premium. The
factor 12 here normalizes by the forward duration, so that the martingale part of this
increment is just the same as that of ft+1 − ft . By “total” risk premium, we mean the
return required by the market for taking the risk associated with the factor ft , but not
made proportional to the volatility of ft .
Figure 4 graphs the results of the kernel density estimates of the drift, volatility
and risk premium of this forward rate series. It is interesting that these functions look
as specified in the Essential Vasicek Model, in that the drift seems to indicate linear
mean reversion, the volatility does not seem to depend on the interest rate, and the risk
premium increases with the interest rate. (These results are different from Stanton’s for
short rates.) As we have mentioned above, kernel density estimation is mis-specified, in
the presence of the predictability which we document. However, it is easy to see that the
volatility here is mostly coming from of the predictable component Xt − ft as above, and
the drift is coming from the slowly moving component Xt .
The Vasicek Model is often criticized on the grounds that it does not allow the volatil-
ity to depend on the interest rate itself, and it assumes that the drift is linear. However,
our kernel density estimation indicates that this criticism does not apply for our imple-
mentation of the Vasicek Model for our long forward rates.

14
3 Predictability and the Risk Premium for T Bond
Futures
The purpose of this section is to repeat the above predictability tests, but replacing the
STRIPs data with T Bond futures data, and to compare the results. The agreement of
the results will give us more confidence that the predictability that we identify, actually
does represent an intrinsic aspect the the far end of the term structure of interest rates.
We can also identify the risk neutral dynamic directly for the T Bond futures, and this
gives us more confidence in our assumption about the risk neutral dynamic of the long
forward rates. We also show that the predictability that we identify can in principle be
exploited for profit, in the T Bond futures market.

3.1 T Bond Futures prices, yields, innovations and returns:

We will use settlement prices for this instrument, for the dates 10/04/77 (the inception of
the contract) to 12/31/99. This contract trades with quarterly maturities, and in recent
years trading has increased in volume and maturities available. Our data was purchased
from the Futures Industry Institute, Washington DC. At settlement of this contract, the
short party can deliver any Treasury bond with maturity of at least 15 years, which is
non-callable within 15 years. In return, the long party pays the short the futures price,
times a conversion factor, which is calculated to be the price of the bond on the first
day of the delivery month, assuming that its yield is 8%. The purpose of this conversion
factor is to render all the eligible bonds to be roughly equivalent, as regards the choice
of the cheapest-to-deliver. (They would be exactly equivalent, if the term structure were
flat at 8%.) For simplicity, we work with the yields implied by the T Bond futures prices,
assuming that the cheapest-to-deliver is a bond with 8% coupon, and maturity 20 years.
The yield for calculating the conversion factor has been changed to 6% for maturities
beginning with March 2000, and we have stopped our data set at 06/30/99 when dealing
with yields (but not with returns), so as to avoid these contracts. If we included these
we would have to be much more careful in our selection of the cheapest-to-deliver, when
we calculate the yields.
Throughout the sequel we will denote by Ytq the T Bond futures price at time t,
and with price linearly interpolated between adjacent maturities, so that the effective
(τ )
maturity time is q. Also, we will denote by Yt the price with term to maturity τ ,
(τ )
i.e. Yt = Ytt+τ . We will denote by ytq and Dtq the corresponding yield to maturity
and duration, assuming that the cheapest-to-deliver bond has 8% coupon and 20 year

15
maturity.
We must distinguish between the futures innovation time series, and the futures return
time series, for a given term to maturity τ . The price innovation over a period δt is
(τ ) (τ )
simply the first difference of the price series itself, i.e. {Yt+δt − Yt }t=0,δt,... ≡ {Yt+δt
t+δt+τ
−
Yt }t=0,δt,... . The (arithmetic) return is {Yt+δt − Yt }t=0,1,2,... , and this is the cash flow
t+τ t+τ t+τ

obtained from rolling over every period a long position in the contract with initial term
to maturity τ 13 .
(τ ) (τ )
We will work at the level of yields yt rather than prices Yt , since these are easier
to interpret in terms of interest rates. In this connection, note that the innovations
(τ ) (τ )
and returns for prices versus yields are connected via the duration; i.e. yt+δt − yt =
(τ ) (τ ) (τ )
−(1/Dtt+τ ) × (Yt+δt − Yt )/Yt and yt+δt t+τ
− ytt+τ = −(1/Dtt+τ ) × (Yt+δt
t+τ
− Ytt+τ )/Ytt+τ ,
to within a convexity adjustment which is negligible for the time steps that we will take.
We will implement some of our tests on the accumulated normalized price returns series,
defined by ft+1 = ft − (1/Dtt+τ ) × (Yt+δt
t+τ
− Ytt+τ )/Ytt+τ ; f0 = (initial yield). This time
series is almost the same as the yield itself, but its first differences are the normalized
futures price returns, and so we can be sure that any predictability resides purely in the
risk premium, because the risk neutralized futures price returns should be a martingale
difference sequence (see Duffie (1996)).
(τ )
Figure 5 gives the time series of yields {yt }t=0,δt,... with τ = 0.25yrs. This figure
(2τ ) (τ )
also includes the time series of the slope { τ1 (yt − yt )}t=0,δt,... , which we will analyze
later.

3.2 The variance ratio test for negative autocorrelation in the

T Bond futures innovations and returns:
We now present the results of applying the Variance Ratio test Lo and MacKinlay (1988),
for autocorrelation of T Bond futures innovations and returns. Table 6 gives the result
of applying the Lo and MacKinlay test to our T Bond futures data, taking a weekly time
step. We have divided our data into two time intervals, at the date 01/01/90, so that the
second interval matches the interval of our STRIPs data. We fail to find autocorrelation
in the first, but negative autocorrelation is strongly significant in the second.
We present our results separately for the yield innovations and for the (arithmetic)
yield returns, as described above. Also, we take maturities at quarterly intervals, increas-
13
Of course, the terms “forward return” and “futures return” are misnomers, though standard when
discussing futures, because there is no investment in these contacts. In using these terms, we have chosen
to sacrifice purity for clarity and succinctness.

16
ing as far as the data allow. The results are essentially the same for each. The results
are also essentially the same (these results are not shown), if we apply the test to the
first differences of the accumulated normalized price returns, defined above.
Our results are also essentially the same for different futures maturities, except that
we have omitted the results for the yield innovations in the more recent interval and
with maturities 0.75 and 1.00 years. These are unreliable, because of the change in the
delivery specification from 8% to 6%, which affects the yield calculations at the end of
this interval. Replacing the yields by the prices also gives essentially equivalent results
(not shown).

3.3 Modelling the negative autocorrelation in the T Bond fu-

tures innovations and returns, via the Kalman filter:
We now apply the Kalman filtering procedure of Lo and Wang (1995) to weekly T Bond
futures data, for the data period 1990 - 2000. In order to be sure that any predictability
is coming from the risk premium, we apply it to the accumulated normalized returns of
the T Bond futures, for which we reserve the notation ft , only in this subsection. To
save space, we also borrow the notation from Equations (5) and (6).
Maximum likelihood estimates of the parameters and their standard errors, are given
in Table 7, and the graphs√of ft , Xt , and the residual Xt − ft are given in Figure 6.
Again, we replace δ by σ f / 2δ in the Maximum Likelihood Estimation, and we see via
the t-statistic on this parameter, that the mean reverting behavior of the innovations is
highly significant. Unfortunately, σ f is not very significant,
√ but this would seem to be
f f
caused by the still high collinearity between σ and σ / 2δ.
Table 8 presents the result of the Variance Ratio Test for autocorrelation, applied to
the time series Xt , ft and Xt − ft . We see that there is little negative autocorrelation
left in Xt , and it has mostly been accounted for in Xt − ft .
We next regress the mean reverting component Xt − ft for the T Bond futures yield
(Figure 6B) on Xt − ft for the STRIPs state variable (Figure 3B). The result is the
following:

(Xtf utures − ftf utures ) = 0.00006 + 0.95944 ×(Xtf orwards − ftf orwards ); R2 = 68.6%
(3.419) (25.605)
(11)
The t statistics here are adjusted via Newey West with 10 lags, for the serial correlation
in the independent variable. This is evidence that the predictable component of the T
Bond yield, and of the STRIPs state variable, largely represent the same market factor.

17
3.4 Can we profit from the predictability in the T Bond Futures
Prices?:
In Subsection 3.3 we fitted Equations (5) and (6), or more particularly, their discretized
versions, Equations (7) and (8), to the T Bond futures data, taking ft to be the cumulative
futures returns, normalized by the duration. The success of the fit indicates that the
factor Xt − ft can be used to predict the futures price at time t + 1. Can we used this
factor to make a profit?
To attempt to make such a profit, we should at each time t take a position in the
futures contract, given by some function q(Y, f ), with Y = Xt − ft and f = ft . For
simplicity, we will consider strategies in terms of their Sharpe ratios, i.e. the ratios
between the average and standard deviations of the weekly cash flows. This gives an
idea of the profitability of a strategy, but ignores the attractions that it might have in
terms of hedging and diversification, in a larger portfolio. Since Equations (7) and (8)
are affine in these variables, then it is easy to show that we should take q(Y, f ) simply
to be linear in Y, f , to maximize the Sharpe ratio of our strategy.
Table 9 first gives the Sharpe ratios for the weekly cash flows, corresponding to the
simple strategy of taking q(Y, f ) = −Y , i.e. taking a position with principal amount
−(Xt − ft )/(duration) in the futures contract, at each weekly time t. It also gives the
t-statistic for the null hypothesis that the Sharpe ratio is zero - this is obtained by
regressing the cash flows on the unit constant, and using the Newey West procedure
allowing for 4 lags. We see that this strategy is indeed profitable.
Second, Table 9 gives the Sharpe ratio of the residual, after regressing the weekly cash
flows form the first strategy, against the weekly cash flows from the normalized futures
return itself, i.e. just maintaining a principal of 1/(duration) in the futures contract. This
residual is automatically orthogonal to the normalized futures return, and corresponds
to the first strategy, but with the futures returns stripped out. The t-statistic for the
Sharpe ratio being zero is again obtained at that on the unit constant in the regression.
We see that the cash flows from the first strategy are correlated with those from the
futures, but this does not account for the profitability of the strategy, because it is still
profitable after the futures returns have been stripped out.
The third Sharpe ratio in Table 9 corresponds to the normalized futures return itself,
We see that this is not significantly different from zero.
The Final Sharpe ratio in Table 9 is included to provide a comparison. This one
corresponds to maintaining a fixed principal in the S&P500 futures index, over the decade
of the 1990s. This Sharpe ratio is very similar to the first and second Sharpe ratios,

18
suggesting that our strategy based on the predictability of the T Bond future is not so
profitable as to present an exceptional opportunity to traders, since it is not significantly
more profitable than investing in stocks.
We should mention here, that our test for opportunity to profit has been done in-
sample, and we have ignored trading costs. On the other hand, the predictability that
we have used, might have benefits which the Sharpe ratio cannot capture, for a more
complete investment strategy, involving stocks and bonds.

3.5 The risk neutral T Bond futures dynamics; kernel density

estimations:
For any futures contract, the risk neutral drift is just the slope of the futures price term
structure. The key to understanding this is the fact (see Duffie (1996)), that the price
trajectory of any futures contract is a martingale with respect to risk neutral probabilities.
In more detail, assume for simplicity that a continuum of contract maturities trade at
any time t. Taking a short time step say δt, the (arithmetic) futures return Yt+δtt+τ
− Ytt+τ
will have expectation zero with respect to risk neutral probabilities, because the terms in
this expression are referring to the same contract, at different times. But the innovation
of the factor Ytτ is given by




t+τ +δt t+τ +δt
Yt+δt − Ytt+τ ≡ Yt+δt − Ytt+τ +δt + Ytt+τ +δt − Ytt+τ . (12)

Transforming to risk neutral probabilities at time t and taking expectations, the first
term on the right hand side of Equation (12) becomes zero. The second term, which is
not random at time t, is just the slope of the futures term structure, times δt. The left
hand side becomes the drift times δt, and so the result follows.
Armed with this insight, and comparing the T Bond futures slope graph in Figure
5B with the graph14 of Xt − ft in Figure 6B, we are able to argue directly for our main
hypothesis concerning the risk premium: that the predictability that we have documented
in the T Bond futures, is not present, when we transform to risk neutral probabilities.
Namely, the slope represents the risk neutral drift of ft , and Xt − ft (multiplied by
δ ≈ 26.0), is the objective drift, as in Equation (5), and it is clear that Figure 5B does
not have the predictable structure of Figure 6B. More formally, the (annualized) volatility
of the slope time series is 0.085 × 1%, and the Variance Ratio test on this slope gives an
insignificant t-statistic of (-1.39). This contrasts with the highly significant results in the
second part of Table 6.
14
Working with yields, rather than prices, introduces a negligible convexity effect.

19
 We now present a kernel density estimation of the objective and risk neutral drifts,
and the volatility, corresponding to the T Bond futures yields. Our implementation of
this is basically as described in Subsection 2.4 above, but taking the T Bond futures
yields, instead of the STRIPs forward rates, and using the slope to estimate the risk
neutral drift.
The results of the kernel density estimates for the T Bond futures yields are given in
Figure 7. In Panel A, we present the estimated drift, slope (i.e. risk neutralized drift) and
total risk premium. The salient feature of this panel is that mean reversion is indicated
for high rates, and in objectively realized probabilities, but mean reversion is much less
in risk neutral probabilities. Also, no mean reversion is indicated in either sense, from
low rates. This observation for the slope bears out the time series graphs of Figure 5, in
which the slope seems to have no relation to the yield, except when the yield is very high.
Finally, the risk premium is generally positive, and increasing with the yield, agreeing
with Stanton15 .
In Panel B of Figure 7, we give the volatility, calculated with a time step of 1 day,
1 week, and 2 weeks. This panel suggests why the data for the period before 1990
did not show evidence of negative autocorrelation. Namely, the rates were positively
autocorrelated, as evidenced by the fact that the shorter time step give a higher volatility,
when they were above about 12%, which was during ‘Fed Experiment’ period of the early
1980s.
Panel C is a histogram of the yields, which indicates that the yields seldom went
above 16%, or below 3%.

4 The Vasicek Model with Predictability

4.1 The risk neutral forward rate dynamic:
Crucial to our full model, is the notion that the predictability that we have identified in
the forward rate dynamic (and corroborated with T Bond futures data), is not present
when we transform to risk neutral probabilities. We were able to establish this directly
for the futures, by identifying the risk neutral drift with the slope of the futures term
structure. More specifically, if the yield on the 20 year, 8% bond represents the ‘long rate’,
then we have shown that this is not predictable, with respect to risk neutral probabilities.
To carry this conclusion over to our forward rates, note that the T bond yield and forward
15
Stanton works with the ‘price of risk’, which is minus our risk premium, and he notes that this is
generally negative.

20
rate differ by a factor which represents shorter interest rates, and and if the forward
price were predictable, then there would have to be a complementary predictability in
the shorter rates, to make the T Bond price no predictable. This would seem unlikely.
In fact, as already mentioned, one would not expect forward rates to be predictable
in the risk neutral probability, and on such a short time scale, since if they were, then
the market would act to obviate this predictability.

4.2 The full model:

Our Vasicek Model with predictability is summarized by the equations

drt = δ(Xt − rt )dt + σ r dWtr , (13)

dXt = κ(X̄ − Xt )dt + σ X dWtX , (14)

for the state variables, and the equation
1
ftq = rt + (R̄ − αrt )B(q − t) − σ r2 B(q − t)2 , (15)
2
for the instantaneous forward rate, in which ftq is the time t instantaneous forward rate
with maturity time q, and B(τ ) is as in Section 2.
Equations (13), (14), (15) are consistent with the risk neutral dynamic being

drt = (R̄ − αrt )dt + σ r dW̃tr , (16)

in which W̃tr is also a Brownian Motion. Equation (16) reflects the notion that the
risk neutral dynamic does not incorporate the predictability in the objective dynamic.
Comparing Equations (13) and (16), we see that the (total) risk premium is (R̄ − αrt ) −
δ(Xt − rt ). The risk premium is thus itself predictable, if δ is positive, but it does not
depend on the general level of rates, if α is zero. Also, the market is incomplete, since
we cannot trade Xt .
A refinement of this model, would be to take the risk neutral drift in Equation (16)
not to be just affine, but to reflect more accurately the dynamic of Figure 5B. However,
since this has such a low volatility, including such a deviation from being constant, would
have a negligible effect on the term structure.
To fit the model to our forward rate data, we combine the Kalman filtering procedures
of Subsections 2.2 and 2.3, adapting equations (13) and (14) for the non-instantaneous
time step, and adapting Equation (15) for our non-instantaneous forward rate data.
Also, we take the state variables (signals) (rt , Xt ) both to be unobservable, and we

21
take the observations ft1 , ...ft6 to include i.i.d., normally distributed errors with variances
r
exp{−21 }, ..., exp{−26 }. Again, we must replace the variable δ by √σ2δ , to obtain con-
vergence.
The parameter estimates for this fit are given in Table 10. This table gives the
estimated value of κ, which is positive, but with large standard error, so that it is not
significantly different from zero; and also the estimate with κ frozen at 0.125.
The time averages of our forward rates and their fitted values, together with the
root-mean-squares (RMSs) of the residuals to the fit, and the estimated values of the
1 6
model standard errors (e− , ..., e− ), are graphed in Figure 8. This verifies that the fit
has captured the downward slope of the forward rate term structure. The time series of
our forward rates and their fitted values, are given in Figure 9, which indicates a close
fit.
As we have said already, we have used the short rate formulation of the Vasicek Model
mainly for convenience, and we do not claim that our “filtered short rate” should agree
with the actual short rate. However, it is interesting to look at the relationship between
the filtered and the actual short rate. This is graphed in Figure 10, with the short rate
given directly by the 3 month T Bill rate. Intuitively, the filtered short rate should
incorporate the long-run dynamics of the actual short rate, i.e. the filtered short rate
should ignore the transient components of the short rate dynamic. Thus, it appears from
Figure 10, that the market anticipated that the very low short interest rates of 1992 - 3,
would not be permanent.

4.3 Comparison to the model without predictability:

r
If we constrain σ r to be zero, which also entails √σ2δ = 0, then the model of this section
reduces to the Essential Vasicek Model of Subsection 2.2. This enables us to use the
Likelihood Ratio test, to compare the models. Actually, when using the Kalman filter, the
likelihood will be affected by the initial (“time zero”) value and standard error assigned
to the signal, and so it is not correct to compare the log-likelihoods of Tables 10 and
2. For the fit of this section, we have taken as initial parameter iterates the converged
values from Tables 2 and 4, and we have taken the initial values (r0 , X0 ) to be equal, and
implied by the Vasicek Model, with these parameters and with the initial observations
(f01 , ..., f06 ). We have taken the initial observation standards error to be 10%. If we run
r
the procedure of this section, with the constraint σ r = 0, √σ2δ = 0, then the estimated
parameters are essentially the same as in Table 2 (not reported), but the maximum log-
likelihood is 14656.95. Comparing this with the log-likelihood 14892.96 of Table 10, we

22
can conclude that the Vasicek Model without predictability is overwhelmingly rejected.
Our model with predictability also has a more conceptual advantage over the Essential
Vasicek Model of Subsection 2.2, relating to the precluding of negative interest rates,
which we discussed there. To preclude negative rates in our model with predictability,
we can impose a reflecting barrier at zero (or slightly above zero), on the variable Xt , so
that rt is never negative. Unlike for the Essential Vasicek Model, this will not greatly
affect the shape and volatility of our forward rates, because the most important factor
in the model is the mean reverting discrepancy rt − Xt .
Our model with predictability superficially resembles that of Jegadeesh and Pennacchi
(1996). These authors are fitting Eurodollar Futures data, going out to term 5 years,
and like us, they have 2 Gaussian state variables, which are filtered from the data.
However, they are not making an assumption like ours for the risk premium. They find
weak evidence for mean reversion, and if their fit were extrapolated to our long maturity
forward rates, it would entail, like many other models, that the long forward rates were
constant.

5 Summary and Suggestions for Further Work

In this paper, we have built an equilibrium term structure model for long maturity
forward rates, and fitted it to the forward rates derived from US Treasury STRIPs prices,
for borrowing/lending at least 13 years in the future, and repaying up to 25 years into
the future. Concentrating on such forward rates enables us to isolate the behavior of the
long lend of the term structure, because they should not be affected by events which the
market anticipates to be history in 13 years’ time. One might expect such forward rates
to be constant, or to have very small volatility, on the basis that the market does not
discount specific anticipated events at such long maturities, but we have been motivated
largely by the fact that this is not the case. These forward rates have a volatility which
is not much lower than the volatility of short interest rates, and the volatility does not
attenuate, as maturity increases. Also, the forward rates slope increasingly downwards,
as maturity increases.
Our model relies on the surprising observation that these long forward rates are
predictable, on a time scale of a few weeks. We have demonstrated this using Lo and
MacKinlay’s variance Ratio test (1988), and by implementing a technique, which was
proposed by Lo and Wang (1995), and which filters out a latent factor Xt , which is itself
not predictable, but to which the predictable forward rate ft mean reverts. In fact most
of the volatility in ft resides in this discrepancy Xt − ft . Moreover, we have corroborated

23
this observation by also demonstrating it in the US Treasury Bond futures market, and
in fact the mean reverting factors Xt − ft are largely the same in each market. We have
also shown that this factor Xt − ft can in principle be exploited for trading in the T Bond
futures.
Our model also relies on the notion that this predictability should not be present
in the risk neutral forward rate dynamic. This seems reasonable, since otherwise the
market would act to obviate this predictability. In fact in our T Bond futures data, we
have argued that we can verify this notion directly, based on the fact that futures prices
must be martingales, so that the risk neutral drift is given by the slope of the futures
price term structure.
As a preliminary to our model fit, we have fit the ‘Essential Vasicek’ Model to our
forward rates, using the standard Kalman filter, to extract a latent state variable rt ,
which we refer to as the ‘filtered short rate’. By the ‘Essential Vasicek’ Model, we mean
the standard Vasicek Model, but with the risk premium being affine in the state variable.
This model falls into the framework of the Essential Affine models of Duffee (2002), and
Dai and Singleton (2002). The ‘filtered short rate’ can be thought of as including the
dynamics of the actual short rate, but with the transient components of this stripped
away. In this Essential Vasicek fit, rates are allowed to be mean reverting in the objective
probability, but not in the risk neutral probability. However, rates have a high risk neutral
probability of becoming negative, before the maturities that we are working with, and
this causes a significant problem for this model.
Our full model fit involves a combination of the filtering technique proposed by Lo
and Wang, and the more orthodox filter corresponding to the Essential Affine fit. We
show that our full model is more likely than the Essential Vasicek Model, as well as
including the predictability that we have documented. Moreover, the full model does not
have and problem with allowing negative interest rates in the risk neutral sense, because
the most important factor in the model is the mean reverting Xt − rt , which is not much
affected by the constraint that rt remain positive.
The work presented here opens a number of avenues for further research. First, we
should try to understand how the factor Xt −ft arises in the market. Does it really reflect
the aggregate aversion to some risk, or does it reflect some aspect of the market structure?
Also, what is the significance of this factor for rational investing and equilibrium pricing
of equities and bonds together? Finally, it would be interesting to build a model for the
entire term structure, incorporating this behavior of long forward rates. In connection
with this, we mention that the factor Xt − ft that we have isolated for long forward rates,
does not seem to be evident in the T Bill futures market.

24
References
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partment, Indiana University.
Brown, S. J. and Dybvig, P. H. (1986), the Empirical Implications of the Cox, Ingersoll, Ross
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Brown R., and Schaefer, S. (1993), Interest Rate Volatility and the Shape of the Term Structure,
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Brown R., and Schaefer, S. (2001), Why Long Forward Interest rates (Almost) Always Slope
Downwards, Working Paper, London Business School.
Campbell, J. Y., Lo, A. W., and MacKinlay, A. C. (1997), The Econometrics of Financial
Markets Princeton University Press.
Carverhill, A. P, Cheuk, T. H. F. and Dyrting, S. (2003), The Price of the Smirk: Returns
to Delta and Vega Neutral Portfolios of S&P500 Futures Options, working paper, University of
Hong Kong.
Chapman, D. A. and Pearson, N. D. (2000), Ts the Short Rate Actually nonlinear?, Journal of
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Cox, J. C., Ingersoll, J. E., and Ross, S. A. (1985), A Theory of the Term Structure of Interest
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Dai, Q and Singleton, K. J. (2002), Expectation Puzzles, Time varying Risk premia, and Dynamic
Models of the Term Structure, Journal of Financial Economics, Vol 63, pp 415 - 441.
Duffee, G. R. (2002), Term Premia and Interest rate Forecasts in Affine Models, Journal of Finance,
Vol 57, pp 405 - 443 .
Duffie, D. (1996), Dynamic Asset Pricing theory, Princeton University Press.
Duffie, D. and Kan, R. (1996), A Yield Factor Model of Interest Rates, Mathematical Finance, pp
379 - 406.
Dybvig, P. H. (1988), Bond and Bond Option Pricing based on the Current term Structure, Working
Paper, School of Business, Washington University, St Louis.
Dybvig, P. H., Ingersoll, J., and Ross, S. (1996), Long Forward and Zero Coupon Rates Can
Never Fall, Journal of Business, Vol 69, pp 1 - 25.
Hamilton, J, D. (1994), Time Series Analysis, Princeton University Press.
Jegadeesh, N and Pennacchi, G. G. (1996), The Behavior of Interest rates Implied by the term
Structure of Eurodollar Futures, Journal of Money, Credit and Banking, Vol, 28, No 3, pp 426 -
446.

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Jordan, B. J. and Kuipers, D. R. (1997), On the Performance of Affine Term Structure Models:
Evidence from the U.S. Treasury Strips market, Working paper, University of Houston.
Karatzas I. and Shreve, S. E. (1988), Brownian Motion and Stochastic calculus, Springer Graduate
Texts in mathematics.
Livingston, M. and Gregory, D. W. (1989), The Stripping of US Treasury Securities, Salomon
Brothers Center for the Study of Financial Institutions Monograph.
Lo, A. W. and MacKinlay, A. C. (1988), Stock Market Prices do not Follow Random Walks:
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41-66.
Lo, A. W. and Wang, J. (1995), Implementing Option pricing Models When Asset Returns are
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Fixed Income.

26
TABLE 1. Summary Statistics for the STRIPs Forward rates
TABLE 1
Summary Statistics for the STRIPs Forward rates
Maturity Average Volatility Principal Components of Volatility
rate
13.0 7.70% 1.02% 0.83% 0.09% 0.21%
15.0 7.62% 1.13% 0.81% -0.69% -0.21%
17.0 7.44% 1.04% 0.78% 0.43% -0.01%
19.0 7.35% 0.99% 0.77% -0.23% -0.12%
21.0 7.06% 1.04% 0.77% -0.02% 0.59%
23.0 6.64% 1.10% 0.82% 0.42% -0.42%
Amount explained by each Principal Component 57.1% 13.4% 9.3%

Notes: The data here is the forward rates derived from US Treasury STRIPs prices, with the maturities
given and each with duration 2 years. The “volatility” is the standard deviation of the forward returns,
as described in Section 1. All these volatilities are expressed on an annualized basis, but are calculated
using weekly returns.

27
 TABLE 2. Estimated Parameters for the “Essential” and Plain Vanilla Vasicek
Model
TABLE 2
Estimated Parameters for the “Essential” and Plain Vanilla Vasicek Model
Essential Vasicek Model Plain vanilla Vasicek Model
Parameter No constraints Forced mean reversion No constraints Forced mean reversion
σ 0.00881 (0.00038) 0.00889 (0.00038) 0.00821 (0.00037) 0.05445 (0.00242)
r̄ 0.07267 (0.00738) 0.06400 (0.03523) 0.19654 (0.41316) -0.01722 (0.15559)
κ 0.6280 (0.5733) 0.1250 (N/A ) -0.00946 (0.00090) 0.125 (N/A )
R̄ 0.00017 (0.00016) 0.00020 (0.00016) -0.00011 (0.00015) 0.02017 (0.00104)
α -0.00796 (0.00094) -0.00796 (0.00092) -0.00946 (0.00090) 0.125 (N/A )
1 -6.3161 (0.0492) -6.3260 (0.0487) -6.3246 (0.0485) -5.7102 (0.0439)
2 -6.4727 (0.0167) -6.4743 (0.0168) -6.4705 (0.0164) -7.0029 (0.0356)
3 -6.6456 (0.0394) -6.6410 (0.0395) -6.6514 (0.0395) -5.9606 (0.0402)
4 -6.2751 (0.0446) -6.2682 (0.0449) -6.2582 (0.0445) -5.5812 (0.0551)
5 -6.0340 (0.0356) -6.0253 (0.0360) -6.0308 (0.0355) -5.1624 (0.0638)

28
6 -5.8936 (0.0367) -5.8970 (0.0367) -5.8898 (0.0368) -4.8975 (0.0761)
log-Likelihood 14795.36 14794.87 14792.37 13083.89
(Standard errors in brackets)

Notes: These parameters are obtained by fitting the Essential Vasicek Model to the weekly time series vector of forward rates with
maturities 13, 15, 17, 19, 21, 23 years, and duration 2 years, over the decade of the 1990s. The Vasicek model is driven by the short
rate equation drt = κ(r̄ − rt )dt + σdWt . In its original, plain vanilla form, the Vasicek takes the risk premium to be a constant λ0 , and
in its “essential” form, it takes the risk premium to be λ0 + λ1 rt . To mitigate collinearity problems, we have replaced the parameters
λ0 and λ1 by R̄ and α, such that α = κ − σλ1 and R̄ = κr̄ + λ0 σ.
TABLE 3. Variance Ratio Statistics for the STRIPs Forward
rates
TABLE 3
Variance Ratio Statistics for the STRIPs Forward rates
Period of Volatility LM statistic
Interest 1 week 2 week
13 yrs - 15 yrs 1.02% 0.96% −2.43
15 yrs - 17 yrs 1.13% 1.01% −1.69
17 yrs - 19 yrs 1.04% 0.98% −1.71
19 yrs - 21 yrs 0.99% 0.95% −1.39
21 yrs - 23 yrs 1.04% 0.92% −4.04∗∗
23 yrs - 25 yrs 1.10% 1.02% −3.13∗∗
13 yrs - 25 yrs 0.80% 0.77% −2.17
(Double asterisk indicates significance at the level 0.1%.)

Notes: This table gives the volatility calculated taking 1 and 2 weekly time steps, for the innovations
of the STRIPs forward rate with maturity 13 years and duration 12 years. It also gives the Lo and
MacKinlay (LM) statistic, which refers to the ratio of these volatilities. This statistic has a standard
normal distribution, under the null hypothesis of no autocorrelation in the time series.

TABLE 4. Mean reverting Fit for the STRIPs Forward Returns

TABLE 4
Mean reverting Fit for the STRIPs Forward Returns
√
Parameter σ f / 2δ σX σf κ X̄
Estimated Value 0.0013548 0.0062045 0.0098358 0.2128149 0.0637357
Standard error 0.0000772 0.0008369 0.0022194 0.2370656 0.0148053
t-statistic 17.55∗∗ 7.41∗∗ 4.43∗∗ 0.90 4.30∗∗
(Fitted value of κ is 26.35 )
Correlations between the scores:
√
σ f / 2δ 1.00000 0.20102 0.73032 -0.09296 -0.01565
X
σ 0.20102 1.00000 -0.18630 -0.26726 0.08822
σf 0.73032 -0.18630 1.00000 -0.03394 -0.04638
κ -0.09296 -0.26726 -0.03394 1.00000 -0.76322
X̄ -0.01565 0.08822 -0.04638 -0.76322 1.00000
Number of data points 520
Log-likelihood value 2795.67
(Double asterisk indicates significance at the level 0.1%.)

Notes: The model being fitted here is summarized by the equations dft = δ(Xt − ft )dt + σ f dWtf ,
dXt = κ(X̄ − Xt )dt + σ X dWtX , where ft is the STRIPs forward rate with maturity 13 years, and
duration 12 years. We see that ft strongly mean reverts to the process Xt .

29
TABLE 5. Autocorrelation of the Filtered Variable Xt , etc., for
the STRIPs Forward Rates
TABLE 5
Autocorrelation of the Filtered Variable Xt , etc
Variable Volatility LM Stat
1 week 2 week
Xt 0.00620 0.00610 -0.70582
ft 0.00803 0.00760 -2.23497
Xt − ft 0.00211 0.00182 −5.13053∗∗
(Double asterisk indicates significance at the level 0.1%.)

Notes: This gives the Lo and MacKinlay test statistic for the filtered component Xt of the STRIPs
forward rate ft , the forward rate ft itself, and the residual, mean reverting component, i.e. Xt − ft . The
first 10 data points have been discarded, to eliminate the initial effects of the Kalman filtering procedure

TABLE 6. Autocorrelations for the T Bond Futures Innovations

and Returns
TABLE 6
Autocorrelations for the T Bond Futures Innovations and Returns
Time period T bond futures differences T bond futures returns
Volatility LM stat Volatility LM stat
maturity 1 week 2 weeks 1 week 2 weeks
10/05/77 - 12/26/89 0.25 years 1.67% 1.72% 1.02 1.69 1.738 1.13
0.50 years 1.66% 1.69% 0.95 1.67 1.714 1.07
0.75 years 1.63% 1.67% 0.88 1.64 1.686 0.97
1.00 years 1.61% 1.65% 0.82 1.62 1.664 0.92
Proportion of the futures returns explained by 1 factor 99.66%
01/02/90 - 06/28/99 0.25 years 0.92% 0.84% −3.49∗∗ 0.92% 0.84% −3.48∗∗
0.50 years 0.92% 0.84% −3.49∗∗ 0.92% 0.84% −3.46∗∗
0.75 years N/A N/A N/A 0.92% 0.84% −3.42∗∗
1.00 years N/A N/A N/A 0.91% 0.83% −3.37∗∗
Proportion of the futures returns explained by 1 factor 99.88%
(Double asterisk indicates significance at the level 0.1%.)

Notes: This table gives the (annualized) volatility calculated taking 1 and 2 weekly time steps, for the
innovations and returns, of the yields associated with the US T Bond futures, and separately over 2 time
periods. It also gives the Lo and MacKinlay (LM) statistic, which refers to the ratio of these volatilities.
This statistic has a standard normal distribution, under the null hypothesis of no autocorrelation in
the time series. We see that over the second period, the innovations and returns have had significant
negative autocorrelation.

30
TABLE 7. Mean reverting Fit for the T Bond Futures Innova-
tions
TABLE 7
Mean reverting Fit for the T Bond Futures Innovations
√
Parameter σ f / 2δ σX σf κ X̄
Estimated Value 0.001629 0.007315 0.01399 0.1493 0.02306
Standard error 0.000615 0.000717 0.00943 0.1302 0.03389
t-statistic 2.64∗ 10.20∗∗ 1.48 1.147 0.68
(Fitted value of κ is 33.38.)
Correlations between the scores:
√
σ f / 2δ 1.00000 -0.04862 -0.99936 -0.09560 0.13159
X
σ -0.04862 1.00000 0.03560 -0.17662 0.08917
σf -0.99936 0.03560 1.00000 0.09844 -0.13281
κ -0.09560 -0.17662 0.09844 1.00000 -0.88475
X̄ 0.13159 0.08917 -0.13281 -0.88475 1.00000
Number of data points 520
Log-likelihood value 2736.06
(Single and Double asterisk indicate significance at the level 1.0% and 0.1% respectively.)

Notes: The model being fitted here is summarized by the equations dft = δ(Xt − ft )dt + σ f dWtf ,
dXt = κ(X̄ − Xt )dt + σ X dWtX , where ft is the cumulative normalized return of the T Bond future, with
time to maturity interpolated to be τ = 3 months. We see that ft strongly mean reverts to the process
Xt .

TABLE 8. Autocorrelation of the Filtered Variable Xt , etc., for

the T Bond Yields
TABLE 8
Autocorrelation of the Filtered Variable Xt , etc
Volatility LM Stat
1 week 2 weeks
Xt 0.00727 0.00707 -1.20525
ft (3 month maturity) 0.01374 0.00909 −8.85907∗∗
Xt − ft 0.00198 0.00162 −6.46815∗∗
(Double asterisk indicates significance at the level 0.1%.)

Notes: This gives the Lo and MacKinlay test statistic for the filtered component Xt of the T Bond
futures yield ft , and the residual, mean reverting component, i.e. Xt − ft . The first 10 data points have
been discarded, to eliminate the initial effects of the Kalman filtering procedure.

31
TABLE 9. Sharpe ratios for some strategies associated with T
Bond futures
TABLE 9
Sharpe ratios for some strategies associated with T Bond futures
Strategy Description Principal amount in Sharpe ratio
the T Bond contract (t-statistic)
1 Use the factor which −(Xt − ft )/(duration) 0.134767
predicts the futures price (3.55)∗∗
2 As Strategy 1, but with the raw −(Xt − ft )/(duration) 0.115050
futures exposure stripped out +0.000154/(duration) (2.79)∗
3 Raw futures exposure 1.0/(duration) 0.071267
(1.78)
4 Constant exposure to the N/A 0.113816
S&P500 futures (3.17)∗
(Single and double asterisk indicates significance at the level 1.0% and 0.1%, respectively.)

Notes: In Strategy 1, the factor Xt − ft is extracted using the Kalman filter, from the cumulative
normalized futures returns. For all strategies, the t-statistic is obtained by regressing the weekly cash
flows of the strategy against the unit constant. In Strategy 2, the raw future returns are stripped out of
Strategy 1, by including them in the regression of the cash flows against the unit constant. The amount
of the futures to take, i.e. 0.000154 is the coefficient in the regression, and the associated t-statistic is
(3.77). The source of the result for Strategy 4 is Carverhill, Cheuk and Dyrting (2003).

32
TABLE 10. Estimated Parameters for the Essential Vasicek
Model with Predictability
TABLE 10
Estimated Parameters for the Extended Vasicek Model with Predictability
Parameter No constraints Forced mean reversion
√
σ r / 2δ 0.0010598 (0.0000385) 0.0010612 (0.0000388)
σX 0.006918 (0.000464) 0.006968 (0.000464)
σr 0.010497 (0.000383) 0.010493 (0.000387)
κ 0.0809 (0.3008) 0.125 (N/A )
X̄ 0.04145 (0.10702) 0.05883 (0.01852)
α -0.008687 (0.000889) -0.008297 (0.000894)
R̄ 0.000866 (0.000186) 0.000875 (0.000186)
1 -6.3033 (0.0492) -6.3067 (0.0490)
2 -6.4276 (0.0168) -6.4317 (0.0169)
3 -6.5283 (0.0399) -6.5309 (0.0399)
4 -6.3287 (0.0432) -6.3299 (0.0431)
5 -6.0600 (0.0361) -6.0556 (0.0360)
6 -5.9588 (0.0355) -5.9535 (0.0355)
log-Likelihood 14892.96 14892.94
(Standard errors in brackets.)

Notes: These parameters are obtained by fitting the Essential Vasicek Model with predictability, to the
weekly time series vector of forward rates with maturities 13, 15, 17, 19, 21, 23 years, and duration 2
years, over the decade of the 1990s.

33
FIGURE 1 - Cross Section and Time Series of Long Forward
rates.
Long Forward Rates from STRIPS, Jan 1990 − Dec 1999

0.1

0.09

0.08

0.07

0.06

0.05

0.04
0
100
200
300 1
2
400 3
500 4
5
600 6
Time in weeks from 01/01/90 Term to Maturity (1 = 13.0 years, ..., 6 = 25.0 year

Notes: This Figure graphs all the forward rates used in our analysis.

34
FIGURE 2 - Investigating the Effect of a Reflecting Barrier at
r = 0.

Panel A: Vasciek term structures, with and without barrier at zero

0.1

0.08

0.06

0.04

0.02

0
0 5 10 15 20 25 30

Panel B: Empirical foward rates at maturity 13 years (x) and 23 years (o)
0.1

0.08

0.06

0.04

0.02

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Notes: In Panel A, the dotted lines represent the term structures in terms of instantaneous forward
rates, starting at r = 0%, 2%, 4%, 6% and 8%, for the Essential Vasicek Model, with parameters given
by the first column of Table 2. The solid lines are the same term structures, if we impose a reflecting
boundary condition at r = 0. Panel B is the empirical time series of the 13 and 23 year forward rates in
our data, i.e. ft1 and ft6 .

35
FIGURE 3 - The STRIPs Forward rates, and their Predictable
Component.

Panel A: Long Duration STRIPs Forward rates: Raw ( ft ) − dots; Filtered part ( Xt ) − solid line
0.11

0.1

0.09

0.08

0.07

0.06

0.05
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

−3 Panel B: Mean Reverting Part, Xt − ft

x 10
2

−1

−2
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Notes: ft and Xt are the forward rate and its filtered component, according to the equations dft =
δ(Xt − ft )dt + σ f dWtf , dXt = κ(X̄ − Xt )dt + σ X dWtX . Panel A graphs these components, and they are
almost indistinguishable in this graph. The difference Xt − ft is graphed in Panel B, and it is clearly
strongly mean reverting.

36
FIGURE 4 - Kernel Density Estimates for the STRIPs Forward
Rates.

Panel A: Drift (−) and total risk premium (o)

0.01

0.005

−0.005

−0.01
0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12
Panel B: Volatility
0.01

0.005

0
0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12
Panel C: Hisogram of the Frequency Distribution
0.3

0.2

0.1

0
0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12

Notes: The top graph here is the kernel density estimate of the drift and total risk premium of
STRIPs forward rate factor, and the second graph is the kernel density estimate of the associated
volatility, both calculated with a weekly time step. The third graph is the frequency distribution for
these forward rates, obtained from the total of the kernel density values, at each forward rate.

37
FIGURE 5 - Time Series of the Yield and Term Structure Slope,
Corresponding to the T Bond Futures Contract.

T Bond Futures Yields

0.2

0.15

0.1

0.05

0
1980 1985 1990 1995 2000

−5 Slope of the Term Sructure of T Bond Futures Yield

x 10
5

−5
1980 1985 1990 1995 2000

(τ )
Notes: The top graph here is time series yt of yields corresponding to the T Bond futures prices,
interpolated to have time to maturity τ = 0.25 years. The bottom graph is the slope, given by τ1 ×
(2τ ) (τ )
(yt − yt ).

38
FIGURE 6 - T Bond Futures Cumulative Normalized Returns,
and their Predictable Component.

Panel A: T Bond Futures Cumulative Returns: Raw ( ft ) − dots; Filtered part ( Xt ) − solid line

0.1

0.08

0.06

0.04

0.02
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

−3 Panel B: Mean Reverting Part, Xt − ft

x 10
2

−1

−2
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Notes The cumulative normalized return is defined by ft+1 = ft − (1/Dtt+τ ) × (Yt+δt

t+τ
− Ytt+τ )/Ytt+τ ;
f0 = (initial yield). This is almost the same as the yield, but its first difference series is the T Bond
futures price returns, and so we can be sure that any predictability is coming from the risk premium.
Xt is the corresponding filtered component, according to the equations dft = δ(Xt − ft )dt + σ f dWtf ,
dXt = κ(X̄ − Xt )dt + σ X dWtX . Panel A graphs these components, and they are almost indistinguishable
in this graph. The difference Xt − ft is graphed in Panel B, and it is clearly strongly mean reverting.

39
FIGURE 7 - Kernel Density Estimates for the T Bond Futures.

Panel A: Drift (−), Total risk premium (o) and Slope (x)
0.04

0.02

−0.02

−0.04
0.04 0.06 0.08 0.1 0.12 0.14 0.16
Panel B: Volatility; daily (−), weekly(x), fortnightly(o)
0.04

0.03

0.02

0.01

0
0.04 0.06 0.08 0.1 0.12 0.14 0.16
Panel C: Hisogram of the Frequency Distribution
0.2

0.15

0.1

0.05

0
0.04 0.06 0.08 0.1 0.12 0.14 0.16

Notes: The top graph here is the kernel density estimates of the drift, risk premium and term
structure slope, calculated from the weekly yields of the T Bond futures. The second graph is the kernel
density estimate of the associated volatility, calculated on a daily, weekly, and fortnightly basis. The
third graph is the frequency distribution for these yields, obtained from the total of the kernel density
values, at each yield value.

40
FIGURE 8 - Average Fit and residuals of the Model.

Average Actual and Fitted Forward Rates +/− Standard Errors

0.08

0.078

0.076

0.074

0.072

0.07

0.068

0.066

0.064
13 14 15 16 17 18 19 20 21 22 23
Term to maturity

Notes: In this Figure, the circles represent the average forward rates of the fitted model, and ± 1
standard error from these averages, as given by the i values in Table 2. The solid line is the average of
the empirically observed forward rates.

41
FIGURE 9 - the STRIPs Forward rates and their Fitted Values.

0.1

0.05
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
0.1

0.05
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
0.1

0.05
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
0.1

0.05
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
0.1

0.05
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
0.1

0.05
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Notes: Each of these graphs contains one of the STRIPs forward rates (thick line), and its fitted value
(thin line). We see that the discrepancies (residuals) between these are small relative to the movements
of the forward rates themselves.

42
FIGURE 10 - the Filtered and Actual Short Rates.

Filtered Short Rate (−) and 3 Month T Bill rate (x)

0.09

0.08

0.07

0.06

0.05

0.04

0.03

0.02
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Notes: In this Figure, the solid line is the filtered short rate, from the Essential Vasicek Model with
predictability, obtained from the long forward rates. The doted line is the actual short rate, represented
by the 3 month T Bill rate. Note that the filtered short rate seems to be more stable than the actual
short rate, and at the time of ‘unusually low’ interest rates, around 1992-3, the T Bill rate is much lower
than the filtered short rate.

43