UNIVERSITEITANTWERPEN

EstimatingtheYieldCurveUsingtheNelsonSiegelModel
ARidgeRegressionApproach

JanAnnaert
UniversiteitAntwerpen,Prinsstraat13,2000Antwerp,Belgium
AnoukG.P.Claes
LouvainSchoolofManagement,BoulevardduJardinBotanique43,1000Brussels,Belgium
MarcJ.K.DeCeuster
UniversiteitAntwerpen,Prinsstraat13,2000Antwerp,Belgium
HairuiZhang
UniversiteitAntwerpen,Prinsstraat13,2000Antwerp,Belgium

Abstract
TheNelsonSiegelmodeliswidelyusedinpracticeforfittingthetermstructureofinterestrates.Dueto
the ease in linearizing the model, a grid search or an OLS approach using a fixed shape parameter are
popularestimationprocedures.Theestimatedparameters,however,havebeenreported(1)tobehave
erratically over time, and (2) to have relatively large variances. We show that the NelsonSiegel model
can become heavily collinear depending on the estimated/fixed shape parameter. A simple procedure
basedonridgeregressioncanremedythereportedproblemssignificantly.

Keywords:SmoothedBootstrap,RidgeRegression,NelsonSiegel,SpotRates
CorrespondingAuthorEmail:marc.deceuster@ua.ac.be

1

1.Introduction
Good estimates of the term structure of interest rates (also known as the spot rate curve or the zero
bond yield curve) are of the utmost importance to investors and policy makers. One of the term
structure estimation methods, initiated by Bliss and Fama (1987), is the smoothed bootstrap. Bliss and
Fama(1987)bootstrapdiscretespotratesfrommarketdataandthenfitasmoothandcontinuouscurve
to the data. Although various curve fitting spline methods have been introduced (quadratic and cubic
splines (McCulloch (1971, 1975)), exponential splines (Vasicek and Fong (1982)), Bsplines (Shea (1984)
and Steeley (1991)), quartic maximum smoothness splines (Adams and Van Deventer (1994)) and
penalty function based splines (Fisher, Nychka and Zervos (1994), Waggoner (1997)), these methods
havebeencriticizedontheonehandforhavingundesirableeconomicpropertiesandontheotherhand
for being black box models (Seber and Wild (2003)). Nelson and Siegel (1987) and Svensson (1994,
1996) therefore suggested parametric curves that are flexible enough to describe a whole family of
observed term structure shapes. These models are parsimonious, they are consistent with a factor
interpretationofthetermstructure(LittermanandScheinkman(1991))andtheyhavebothbeenwidely
used in academia and in practice. In addition to the level, slope and curvature factors present in the
NelsonSiegel model, the Svensson model contains a second hump/trough factor which allows for an
evenbroaderandmorecomplicatedrangeoftermstructureshapes.Inthispaper,werestrictourselves
to the NelsonSiegel model. The Svensson model shares by definition all the reported problems of
the NelsonSiegel approach. Since the source of the problems, i.e. collinearity, is the same for both
models,thereportedestimationproblemsoftheSvenssonmodelmaybereducedanalogously.
The NelsonSiegel model is extensively used by central banks and monetary policy makers (Bank of
International Settlements (2005), European Central Bank (2008)). Fixedincome portfolio managers use
the model to immunize their portfolios (Barrett, Gosnell and Heuson (1995) and Hodges and Parekh
(2006))andrecently,theNelsonSiegelmodelalsoregainedpopularityinacademicresearch.Dullmann
andUhrigHomburg(2000)usetheNelsonSiegelmodeltodescribetheyieldcurvesofDeutscheMark
denominated bonds to calculate the risk structure of interest rates. Fabozzi, Martellini and Priaulet
(2005) and Diebold and Li (2006) benchmarked NelsonSiegel forecasts against other models in term
structure forecasts, and they found it performs well, especially for longer forecast horizons. Martellini
and Meyfredi (2007) use the NelsonSiegel approach to calibrate the yield curves and estimate the
valueatrisk forfixedincome portfolios.Finally, the NelsonSiegelmodel estimatesarealso usedasan
inputforaffinetermstructuremodels.Coroneo,NyholmandVidavaKoleva(2008)testtowhichdegree
2

the NelsonSiegel model approximates an arbitragefree model. They first estimate the NelsonSiegel
model and then use the estimates to construct interest rate term structures as an input for arbitrage
freeaffinetermstructuremodels.TheyfindthattheparametersobtainedfromtheNelsonSiegelmodel
are not statistically different from those obtained from the pure noarbitrage affineterm structure
models.
Notwithstanding its economic appeal, the NelsonSiegel model is highly nonlinear which causes many
users to report estimation problems. Nelson and Siegel (1987) transformed the nonlinear estimation
problem into a simple linear problem, by fixing the shape parameter that causes the nonlinearity. In
ordertoobtainparameterestimates,theycomputedtheOLSestimatesofaseriesofmodelsconditional
uponagridofthefixedshapeparameter.Theestimatesthat,conditionaluponafixedshapeparameter,
maximizedtheRwerechosen.Werefertotheirprocedureasagridsearch.Othershavesuggestedto
estimate the NelsonSiegel parameters simultaneously using nonlinear optimization techniques. Cairns
andPritchard(2001),however,showthattheestimatesoftheNelsonSiegelmodelareverysensitiveto
the starting values used in the optimization. Moreover, time series of the estimated coefficients have
been documented to be very unstable (Barrett, Gosnell and Heuson (1995), Fabozzi, Martellini and
Priaulet (2005), Diebold and Li (2006), Gurkaynak, Sack and Wright (2006), de Pooter (2007)) and even
to generate negative long term rates, thereby clearly violating any economic intuition. Finally, the
standarderrorsontheestimatedcoefficients,thoughseldomreported,arelarge.
Althoughtheseestimationproblemshavebeenrecognizedbefore,ithasneverleadtowardssatisfactory
solutions.Instead,itbecamecommonpracticetofixtheshapeparameteroverthewholetimeseriesof
term structures.
1
Hurn, Lindsay and Pavlov (2005), however, point out that the NelsonSiegel model is
very sensitive to the choice of this shape parameter. de Pooter (2007) confirms this finding and shows
thatwithdifferentfixedshapeparameters,theremainingparameterestimatescantakeextremevalues.
Hencefixingtheshapeparameterisanontrivialissue.Inthispaperweuseridgeregressiontoalleviate
theobservedproblemssubstantiallyandtoestimatetheshapeparameterfreely.
Theremainderofthispaperisorganizedasfollows.InSection2,weintroducetheNelsonSiegelmodel.
Section3presentstheestimationproceduresusedintheliterature,illustratesthemulticollinearityissue
which is conditional on the estimated (or fixed) shape parameter and proposes an adjusted procedure
based on the ridge regression. In the subsequent section (Section 4) we present our data and their

1
Barrettetal.(1995)andFabozzietal.(2005)fixthisshapeparameterto3forannualizedreturns.DieboldandLi
(2006)chooseanannualizedfixedshapeparameterof1.37toensurestabilityofparameterestimation.
3

descriptivestatistics.Sincetheridgeregressionintroducesabiasinordertoavoidmulticollinearity,we
willmainlyevaluatethemeritsofthemodelsbasedontheirabilitytoforecasttheshortandlongendof
the term structure. The estimation results and the robustness of our ridge regression are discussed in
Section5.Finally,weconclude.

2.AfirstlookattheNelsonSiegelmodel
IntheirmodelNelsonandSiegel(1987)specifytheforwardratecurvef()asfollows:
( )
( )
0 0 0
/
1 1 1
/
2 2 2
1
,
/
f
f e f
e f

= =








(2.1)
where

istimetomaturity,
0
,
1
,
2
and

arecoefficients,with>0.
Thismodelconsistsofthreepartsreflectingthreefactors:aconstant(f
0
),anexponentialdecayfunction
(f
1
) and a Laguerre function (f
2
). The constant represents the (longterm) interest rate level. The
exponentialdecayfunctionreflectsthesecondfactor,adownward(
1
>0)orupward(
1
<0)slope.The
Laguerre function in the form of
x
xe
,
is the product of an exponential with a polynomial. Nelson and
Siegel (1987) chose a first degree polynomial which makes the Laguerre function in the NelsonSiegel
model generate a hump (
2
> 0) or a trough (
2
< 0). The higher the absolute value of
2
, the more
pronouncedthehump/troughis.Thecoefficient,referredtoastheshapeparameter,determinesboth
the steepness of the slope factor and the location of the maximum (resp. minimum) of the Laguerre
function.
The spot rate function, which is the average of the forward rate curve up to time to maturity , is
definedas:

( ) ( )

=

0
1
, r f u du (2.2)
withcontinuouscompounding.Hence,thecorrespondingspotratefunctionattimetomaturityreads

Figure1d
(respectiv
rate(thes

Fig
PanelA:F
Note:Thisf
spotratecu
PanelB)rep
Theroleo
time to m
vanishan

0
.Based
to be neg
compone
the slope
slope. Th
compone
depictstheth
velyr
0
,r
1
and
spotrate)cur
gure1:Decom
FortheForwa
figureshowsthe
urve(PanelB)w
presenttheleve
ofthecompo
maturity. Wh
dthelongte
oneconomic
gative or unre
ntvanishesa
e of the term
e degree of
nt decay to
( )

r
hreebuilding
r
2
inPanelB)
rve.
mpositionoft
ardRateCurv
edecomposedc
whentheshapep
l,slopeandcurv
onentsbecom
en the time
rmforwarda
cintuition,w
ealistically hi
andtheforwa
m structure, w
the curvatu
o zero. Final
(
(

0
1
2
1
1 e
blocksofthe
)representth
theNelsonS
ve
componentsoft
parameterisfixe
vaturecompone
mesclearwhe
to maturity
andspotrate
weassume
0
gh. When th
ardandthesp
whereby a ne
re is control
lly, the loca
4
)
)

/
/
1
1 /
/
e
e e
eNelsonSieg
helevel,slope
iegelModelw
Pane
theNelsonSiege
edat3.Thecur
entsoftheforwa
enwelookat
grows to inf
willconverge
tobecloset
e time to ma
potrateconv
egative (posit
led by
2
, th
ation of the

0
1
/
2
gelmodel.Th
eandcurvatu
withtheSha
elB:fortheS
elmodelforthe
rvesf
0
,f
1
andf
2
ardrate(thespo
theirlimiting
finity, the slo
etothesame
otheempiric
aturity appro
vergeto(
0
+
tive)
1
repre
he rate at w
e maximum/





0
1
2
.
r
r
r
hecurvesf
0
,f
urecompone
peParamete
SpotRateCur
eforwardratec
inPanelA(resp
otrate)curve.
gbehaviourw
ope and curv
econstantlev
callongterm
oaches zero, o

1
).Thespre
esents an up
which the slo
minimum va
f
1
andf
2
inPa
entsofthefor
erFixedat3
rve
urve(PanelA)a
pectivelyr
0
,r
1
an
withrespectt
vature compo
velofinterest
mspotratean
only the curv
ead,
1
,mea
pward (downw
ope and curv
alue of curv
(2.3)
anelA
rward

andthe
ndr
2
in
tothe
onent
trate,
ndnot
vature
asures
ward)
vature
vature

compone
the hump
function w
structure.
In Figure
paramete
maximum
determine

PanelA:i
Note: This f
various sha
whereastha
Equation2.3

Alternativ
tomaturi
facilitates
themaxim
maximizin
hump/tro
ntisdetermi
p/trough of
with respect
.
2 the curvat
ers ranging fr
m when = ,
edbysimply
intheForwar
figure shows the
pe parameters.
atinthespotra
3withfixed.
vely,wecanf
ty,byfixingt
sestimation.
mumofthec
ng the curva
ough become
nedby.Not
the term str
to , we ar
ture compon
rom 1 to 10
, whereas th
maximizingr
2
Figure
rdRateCurve
e shapes of the
The curvature
atecurve(Panel
forcetheloca
theshapepa
Severalautho
curvaturecom
ature compo
es approxima
tethatdete
ructure. By m
e able to de
nent in the f
0. The curvat
at in the spo
2
inEquation
e2:Shapesof
e
e curvature com
component in t
B)reachesitsm
ationoftheh
rametertoa
orsusethisid
mponentinth
onent in th
tely 1.37 wit
5
erminesboth
maximizing th
etermine the
forward rate
ture compon
ot rate curve
2.3withfix
ftheCurvatu
Pane
ponent in the f
the forward rat
maximumwhen
hump/trough
specificvalu
dea.Intheire
hespotratef
e spot rate
th annualized
theshapeof
he curvature
location of
and the spo
ent in the f
reaches its m
xed.
ureCompone
elB:intheSp
forward rate an
te curve (Panel
>,whichisd
oftheterm
ue.Thisalsol
empiricalwor
functionata
e function, t
d data. In Fa
fthecurvatu
e component
the hump/tr
ot rate are d
orward rate
maximum wh
nt
potRateCurv
d the spot rate
A) reaches its m
determinedbys
structureto
inearizesthe
rk,Dieboldan
amaturityof
the shape p
abozzi et al. (
recomponen
t in the spot
rough of the
depicted for s
curve reach
hen > , wh
ve
curve with resp
maximum when
simplymaximizin
beatagiven
emodelandh
ndLi(2006)e
2.5years.Th
parameter o
(2005), wher
ntand
t rate
term
shape
es its
hich is

pect to
n = ,
ngr
2
in
ntime
hence
e.g.fix
husby
f the
re the
6

shapeparameterwasset tobe3,the humpislocatedapproximatelyatamaturityof5.38onthespot
ratecurve.

3.Estimationprocedures
In order to obtain all the parameter estimates simultaneously, we could use nonlinear regression
techniques. Ferguson and Raymar (1998) and Cairns and Pritchard (2001), however, show that the
nonlinear estimators are extremely sensitive to the starting values used and that the probability of
gettinglocaloptimaishigh.Takingthesedrawbacksintoaccount,mostresearchershavefixedtheshape
parameter and have estimated a linearized version of the NelsonSiegel model. The parameters of the
NelsonSiegelmodelhavetypicallybeenestimatedbyminimizingthesumofsquarederrors(SSE)using
(1)OLSoveragridofprespecifieds(NelsonandSiegel(1987)),and(2)alinearregression,conditional
onachosenfixedshapeparameter(DieboldandLi(2006),dePooter(2007),andFabozzietal.(2005)).
Werefertothesemethodsasthetraditionalmeasures.Theestimatedparametersusingthetraditional
methods, however, are reported (1) to behave erratically in time, and (2) to have relatively large
variances. We will first show that these problems result from multicollinearity problems. Next, we
introduce a ridge regression approach to remedy the reported problems and how to judiciously fix the
shapeparameterinordertoestimatethelinearizedNelsonSiegelmodel.

3.1.Thenatureofthemulticollinearityproblem
Researchers have been aware of potential multicollinearity issues while estimating the NelsonSiegel
model.DieboldandLi(2006) e.g.indicate that the highcorrelationbetweenthefactorsof theNelson
Siegel (1987) model makes it difficult to estimate the parameters correctly. What seems to have gone
unnoticed,however,isthefact that thecorrelation betweenthe tworegressorsofthemodeldepends
on(thetimestomaturityof)thefinancialinstrumentschoseninthebootstrap.Inordertoillustratethis
point,weconsiderfourdifferentsetsoftimestomaturity:
1. 3and6months,1,2,3,4,5,7,10,15,20and30years;
2. 3,6,9,12,15,18,21,24,30months,310years;
3. 1week,112month,and210years;
4. 1week,6months,and110years.
7

ThefirstsetofmaturitieswasusedbyFabozzietal.(2005).DieboldandLi(2006)optedforthesecond
maturity vector. Since researchers are inclined to use all the data they can find, we study two extra
vectorsthatalsoincludeadditionalshortertimetomaturities.
Table 1 summarizes the correlations between the regressors for the values chosen by Diebold and Li
(2006)andFabozzi etal.(2005),using thefourvectorsoftime tomaturity thatweconsider.Thetable
showsthatthecorrelationbetweentheslopeandthecurvaturecomponentoftheNelsonSiegelmodel
heavily depends on the choice of the shape parameter. The second maturity vector e.g. implies
correlationsvaryingbetween5%and87%dependingontheshapeparameterchosen.Thecorrelation
alsodependsseverelyonthechoiceofthetimetomaturityvector.Using=1.37,thecorrelationvaries
from0.549to0.256,forthematurityvectorschosen.Setting=3producescorrelationsfrom0.324to
0.931. The vector containing the series of short maturities (the third vector) turns out to be the most
sensitivetothecollinearityissue.

Table1:CorrelationbetweenRegressorsUsingAlternativeTimetoMaturityVectors
MaturityVector DieboldandLi(=1.37) Fabozzietal.(=3)
1 0.256 0.324
2 0.051 0.871
3 0.549 0.931
4 0.352 0.872
Note:ThecorrelationsbetweentheregressorsintheNelsonSiegelspotratefunctionconditionedontheshapeparameterand
thevectoroftimestomaturityarepresented.Vector1usesthefollowingtimestomaturity:3and6months,1,2,4,5,7,10,15,
20and30years(asinFabozzietal.(2005));vector2uses3,6,9,12,15,18,21,24,30monthsand310years(asinDieboldand
Li(2006));vector3isbasedon1week,112monthsand210years;andvector4on1week,6monthsand110years.

Figure 3 gives a more complete picture by plotting the correlation between the two regressors over a
range of values using the four time to maturity vectors studied. We notice that the choice of the
maturity vector influences the steepness of the correlation curve. It appears that Fabozzi et al. (2005)
andDieboldandLi(2006)chosetheirvaluesjudiciouslyconditionalontheirmaturityvector,although
they both motivate their choice differently. It is clear that for empirical work it is of the utmost
importanceforalloftheestimationmethodstotakethispotentialmulticollinearityissueintoaccount.

Note: This f
ratecurveo
6months,1
and310ye
6monthsan

3.2Tradit
3.2.1Grid
Toavoidn
estimate
values ra
paramete
the time
(1995),Ca
anddePo
ofthisins

3.2.2OLS
Someres
curvature
Figur
figure plots the
overtheshapep
1,2,4,5,7,10,
ears(asinDiebo
nd110years.
tionalestima
dsearchbase
nonlinearest
Equation 2.3
nging from 0
erset. Inprac
series of est
airnsetal.(2
ooter(2007).
stability.More
withfixedsh
earchersfix t
eofthespotr
re3:Correlat
correlations be
parameterusin
15,20and30y
ldandLi(2006)
tionmethod
edOLS
imationproc
3 with ordina
0.027 to 1. T
ctice,itis we
timates. This
001),Fabozzi
Farlessobse
eover,highm
hapeparame
theshapepa
rates.
tionsbetwee
tween the slope
ngfourtimetom
years(asinFabo
);vector3isbas
s
edures,Nelso
ry least squa
he estimates
llknown that
has been po
ietal.(2005)
ervedisthat
multicollineari
eters
rameterwhic
8
ntheSlopea
e and curvature
maturityvectors
ozzietal.(2005)
sedon1week,
onandSiegel
ares. This pro
s with the hig
tgrid search
ointed out by
),Dieboldeta
multicollinea
itycanalsoin
ch theytypica
andCurvature
e component of
s.Vector1uses
));vector2uses
112monthsan
l(1987)linea
ocedure was
ghest R wer
basedOLSle
y many resea
al.(2006and
rityamongth
nflatethevari
allymotivate
eComponen

the NelsonSieg
thefollowingtim
s3,6,9,12,15,
nd210years;an
arizetheirmo
repeated for
re then chos
eadstoparam
archers inclu
d2008),Gurka
hetworegre
ianceofthee
eby priorkno
t
gel model for th
mestomaturity
18,21,24,30m
ndvector4on1
odelbyfixing
r a whole grid
sen as the op
meterinstabi
ding Barrett
aynaketal.(
ssorsisthes
estimators.
owledgeabou
he spot
y:3and
months
1week,
and
d of
ptimal
lityin
et al.
2006)
ource
ut the
9

Diebold and Li (2006) set to 16.4 with monthly compounded returns, or approximately 1.37
with annualized data. Their choice implies that the curvature component in the spot rate
function will have its maximal value at the time to maturity of 2.5 years. They motivated their
choicebystatingthatmostofthehumps/troughsarebetweenthesecondandthethirdyear.As
we have shown, this choice, also turned out to avoid multicollinearity problems for their
maturityvector.
Fabozzietal.(2005)fixedto3withannualizeddata,asarguedbyBarrettetal.(1995).Barrett
et al. (1995) performed a grid search by fixing for the whole dataset and obtained a global
optimalshapeparameterinonego.Inafootnote,Fabozzietal.(2005)mentionthatwhenthe
shapeparameterisfixedat3,thecorrelationbetweenthetworegressorswillnotcausesevere
problems for their data. They, however, do not offer a universal procedure to tackle the
multicollinearityissue.
From the previous section, we know that the degree of multicollinearity depends on the choice of the
fixed shape parameter and the choice of the vector of times to maturity. The shape parameter that
minimizesthesquarederrorsmayalsovaryovertime.Figure4plotsthespotratecurveontwodays(i.e.
April18,2001andJanuary4,1999)wherefixingtheoptimalshapeparametertoeither1.37or3visually
underperformscomparedtothegridsearch.Thevaluesestimatedusingthegridsearcharereported
inthefigure.Onthelefthandside,theshapeparameterisestimatedtobe1.35.Theuseofafixedof
1.37willthereforeresultinabetterfitthanthemodelwithashapeparameterfixedat3.Ontheright
handside,however,thegridsearchestimateofis2.9.Themodelusingafixedof3willthusfitthe
databetterthanthatusingashapeparameterof1.37.

PanelA(
Note:Thisf
(2.9) which
parametero

3.2.3Grid
Whereas
optimal e
Nelson an
paramete
ridge reg
therefore
discussed
implemen

3.2.3.1M
In order t
collinearit
number.
TheVIFis
Fig
Date:April18
figuregivesane
minimizes the f
of1.37(3)result
dsearchwith
linear regres
estimators, th
nd Siegels ap
er. Conditiona
gression whe
need to tes
below. Su
ntationofthe
Measuringthe
to address th
ty measures
definedas
ure4:AnExa
8,2001)
exampleofthel
fitting errors in
tsinabetterfit
conditional
ssions do not
hey do suffer
pproach by co
al on the th
never the d
st the degre
bsequently,
eridgeregres
degreeofm
he multicollin
include the v
ampleofthe
imitationoffixe
Panel A (Panel
thanthemodel
ridgeregress
t require star
r from instab
ombining the
hat results in
egree of mu
ee of multico
we discuss
sionfortheN
ulticollineari
nearity issue,
variation infla
10
Limitationof
Pane

edshapeparame
B). As a conseq
withafixedsha
sion
rting values f
bility in param
e grid search
n the highest
ulticollinearit
ollinearity of
the nature
NelsonSiegel
ty
, we need to
ation factor (
fFixedShape
elB(Date:Ja
eter.Thegridse
quence, the Nel
apedparameter
for the estim
meter estima
with the OLS
R, the para
ty among th
the two fac
e of ridge
termstructu
o verify the d
(VIF), the tole
eParameter
nuary4,199
earchgivesash
sonSiegel mod
of3(1.37).
mators and al
ation. In this
S regression t
ameters are r
e regressors
ctors. The m
regression
ureestimation
degree of co
erance level
9)
apeparameter
el with a fixed s
ways give glo
paper, we f
to free the s
reestimated
s is too high
measure we u
and present
n.
ollinearity. Po
and the con

of1.35
shaped
obally
follow
shape
using
h. We
use is
t the
opular
dition
11

2
1
,
1
i
R

where R
i
is the coefficient of multiple determination of the independent variable X
i
on all other Xs in
themodel.TheintuitionofVIFforasimpleregressionisstraightforward:ifthecorrelationbetweenthe
regressorsishigh,thentheVIFwillbelarge.ThetolerancelevelisthereciprocalofVIF.
Belsley(1991)pointsoutthemaindrawbacksofthesetwomeasures:(1)highVIFsaresufficientbutnot
necessary to collinearity problem, and (2) it is impossible to determine which regressors are nearly
dependent on each other by using VIFs. The third measure, the condition number, is based on the
eigenvalues of the regressors. Since the condition number avoids the shortcomings of the
aforementioned methodologies(seeBelsley(1991) andDeMaris(2004)),weusetheconditionnumber
asthecollinearitymeasure.Assumethereisastandardizedlinearsystemy=X+.Denote(kappa)as
theconditionnumberandtheeigenvaluesofXX.TheconditionnumberofX

isdefinedas
( ) =
max
min
1.
v
v
X (3.1)
IfX

iswellconditioned(i.e.theregressorcolumnsareuncorrelated),thentheconditionnumberisone,
which implies that the variance is explained equally by all the regressors. If correlation exists, then the
eigenvaluesarenolongerequalto1.Thedifferencebetweenthemaximumandminimumeigenvalues
willgrowasthecollinearityeffectincreases.AssuggestedbyBelsley(1991),weuseaconditionnumber
of10asameasureofthedegreeofmulticollinearity.
2

3.2.3.2Remedyofhighcollinearity
Once collinearity is detected, we need to remedy the problem. To overcome OLS parameter instability
due to multicollinearity, we implement an alternative to the linear regression, i.e. the ridge regression
technique. This estimation procedure can substantially reduce the sampling variance of the estimator,
by adding a small bias to the estimator. Kutner, Nachtsheim, Neter and Li (2004) show that biased
estimatorswithasmallvariancearepreferabletotheunbiasedestimatorswithlargevariance,because

2
As there are only two regressors in the NelsonSiegel model, we can plot a onetoone relationship between the condition
number and the correlation between the two regressors. In our dataset, a condition number above 10 is equivalent to a
correlationwithanabsolutevalueabove0.8.
12

the small variance estimators are less sensitive to measurement errors. We therefore use the ridge
regressionandcomputeourestimatesasfollows:
[ ]

= +

1
*
, k X X I X y (3.2)
wherekiscalledtheridgeconstant,whichisasmallpositiveconstant.Astheridgeconstantincreases,
the bias grows and the estimator variance decreases, along with the condition number. Clearly, when
k=0theridgeregressionisasimpleOLSregression.

3.2.3.3Implementation
As pointed out by Kutner et al. (2004), collinearity increases the variance of the estimators and makes
the estimated parameters unstable. However, even under high collinearity, the OLS regression still
generates theunbiasedestimates.As aresult,weimplementa combination ofthegridsearchand the
ridgeregressionusingthefollowingsteps:
1. PerformagridsearchbasedontheOLSregressiontoobtaintheestimateofwhichgenerates
thelowestmeansquarederror.
2. Calculatetheconditionnumberfortheoptimal.
3. Reestimatethecoefficientsbyusingridgeregressiononlywhentheconditionnumberisabove
aspecificthreshold(e.g.10).Thesizeoftheridgeconstantischosenusinganiterativesearching
procedure
3
that finds the lowest positive number, k, which makes the recomputed condition
numberfallbelowthethreshold.Byaddingasmallbias,thecorrelationbetweentheregressors
willdecreaseandsowilltheconditionnumber.

4.Dataandmethodology
To illustrate our NelsonSiegel term structure fitting procedure, we use Euribor rates maturing from 1
week up to 12 months and Euro swap rates with maturities between 2 years and 10 years. The Euro
Overnight Index Average (EONIA), and the 20, 25 and 30year Euro swap rates were also collected to
assess the outofsample prediction quality of the selected estimation procedures. The Euribor and

3
Westartwithk=0andweiterativelyrecomputetheconditionnumberafterincreasingtheridgeconstantwith0.001.We
stopiteratingwhentherecomputedconditionnumberislowerthantheprespecifiedthreshold(i.e.10).
13

EONIA rates were obtained from their official website, and the Euro swap rates were gathered from
Thompson DataStream. Our dataset spans the period from January 4, 1999 to May 12, 2009 and
includes2644days.
Weusethesmoothedbootstraptoconstructthespotratecurves:
1. AstheEuriborrates,R(),withmaturitieslessthanoneyearusesimpleinterestrateswiththe
actual/360daycountconvention,weconvertthemto
( ) ( ) = +

365/
1 / 360 ,
Actual
Days
actual
R R Days (4.1)
whereR()istheannuallycompoundedEuriborrateusingactual/365dateconvention.
2. Swapratesareparyields,sowebootstrapthezerosrates.DenoteS()astheswaprate,timeto
maturitybeing.Thefollowingequationhelpsustoextractthespotratesfromtheswaprates:
( ) ( )
( )

=

=
+

1/
1
1
1 1.
1
j
j
R S
R j
(4.2)
Here=2,...,10andtheEuroswapratesusetheactual/365daycountconvention.
3. AstherelationshipbetweenEquation2.1and2.3onlyholdsforcontinuouslycompoundedrates,
weneedtoconverttheannualizedspotratestocontinuouslycompoundedrates:
( ) ( ) = +

log 1 . r R (4.3)
Table2summarizesthedescriptivestatisticsforthetimeseriesofcontinuouslycompoundedspotrates
we use to fit the spot rate curve. The table shows that the volatility of the time series increases from
0.98%forweeklyratesto1.03%for3monthrates,andthengoesdownto0.69%for10yearspotrate.
Theaveragespotrateincreasesastimetomaturitygrows,from3.16%fortheoneweekrate,to4.53%
fora10yearmaturity.Autocorrelationishighforratesofallmaturities,fromabove0.998witha5day
lagtoabove0.915witha255daylag.

14

Table2:DescriptiveStatisticsofSpotRates(RatesAreinPercentage)
Maturity Mean

Std.Dev.

Min. Max. ( )

5 ( )

25 ( )

255
1Week 3.186 0.982 0.710 5.240 0.998 0.972 0.926
1Month 3.238 0.995 0.866 5.257 0.999 0.975 0.926
2Months 3.292 1.013 1.111 5.299 0.999 0.980 0.935
3Months 3.334 1.030 1.307 5.431 0.999 0.983 0.941
4Months 3.351 1.027 1.379 5.441 0.999 0.984 0.944
5Months 3.364 1.026 1.435 5.442 0.999 0.984 0.944
6Months 3.377 1.025 1.501 5.449 0.999 0.984 0.945
7Months 3.388 1.022 1.535 5.448 0.999 0.984 0.945
8Months 3.400 1.020 1.566 5.445 0.999 0.984 0.945
9Months 3.413 1.019 1.590 5.448 0.999 0.984 0.944
10Months 3.426 1.017 1.613 5.444 0.999 0.984 0.943
11Months 3.439 1.015 1.636 5.440 0.999 0.983 0.943
12Months 3.453 1.014 1.656 5.451 0.999 0.983 0.942
2Years 3.568 0.911 1.724 5.435 0.998 0.974 0.923
3Years 3.742 0.845 2.160 5.513 0.998 0.972 0.918
4Years 3.895 0.796 2.383 5.563 0.998 0.970 0.915
5Years 4.029 0.762 2.599 5.614 0.998 0.971 0.916
6Years 4.153 0.740 2.729 5.692 0.998 0.971 0.920
7Years 4.267 0.726 2.845 5.755 0.998 0.973 0.925
8Years 4.369 0.716 2.951 5.820 0.998 0.974 0.928
9Years 4.456 0.705 3.047 5.891 0.998 0.975 0.932
10Years 4.530 0.696 3.134 5.957 0.998 0.975 0.934
Note:Spotratesareexpressedinpercentagewithcontinuouscompounding.ThesampleperiodrunsfromJanuary4,1999to
May 12, 2009, totaling to 2644 days. The spot rates with maturities less than one year are retrieved from the Euribor rates,
whereas those with a maturity of more than one year are bootstrapped from Euro swap rates. Both are converted to obtain
rateswithaccordingtotheactual/365(ISDA)dateconvention. ( )

n isthendaylagautocorrelation.

Note: This f
2009, totali
maturities l
bootstrappe
convention.

Figure 5 p
data set c
shortterm
0.7% in 2
3.134%an
theyieldc
compared

Fig
figure plots the
ng to 2644 day
ess than one ye
ed from Euro s
.
plots the tim
contains a lot
mspotrates
2009, due to
ndalmost6%
curves,while
dtotheSsha
gure5:TimeS
time series of t
ys with the follo
ear are retrieved
swap rates. Bo
e series of m
t of variation
(1 week)var
the financial
%.Theyieldc
atothertime
apedcurvesin
Seriesofthe
the Euro spot ra
owing times to m
d from the Eurib
th are converte
monthly spot
in the level,
yfromappro
crisis. The lo
curveismost
estherearet
notherperiod
15
EuroSpotRa
ate curve. The s
maturity: 1 wee
bor rates, where
ed to obtain ra
rates in 3 di
the slope an
oximately3.7
ongterm spo
oftenupwar
troughs.Betw
ds.
ateCurves(1
sample period r
ek, 112 months
eas those with a
ates with acco
mensions. W
nd the curvat
5%to5%in
ot rate is rela
rdsloping.Ar
ween2003an
9992009)
runs from Janua
s and 210 year
a maturity of m
rding to the a
We can clearly
ture of the te
2008,andde
atively stable
round2006t
nd2005they

ary 4, 1999 to M
rs. The spot rate
more than one ye
ctual/365 (ISDA
y observe tha
erm structure
ecreasestoa
e, varying bet
herearehum
ieldcurveisf
May 12,
es with
ear are
A) date
at our
e. The
lmost
tween
mpsin
flatter
16

5.EmpiricalComparisonoftheEstimationMethods
Inordertocomparethedifferentestimationmethods,weevaluatetheestimationproceduresbasedon
the mean absolute error of their forecasting performance (the Mean Absolute Prediction Error or in
shorttheMAPE).Theabsoluteerrorismeasuredinbasispointswhichgivesusagoodindicationofthe
economic importance of the results. For every day in our time series we estimate the NelsonSiegel
modelbasedontheproposedestimationmethods,i.e.forthegridsearch,theOLSwiththefixedshape
parameterand thegridsearch usingthe conditionalridgeregression.We then usetheestimated term
structures to forecast the spot rates used in the estimation (insample forecasting) and the
contemporaneous EONIA, 20, 25 and 30year Euro swap rates (outofsample forecasting). The
estimation procedure which produces (over the available time series) the lowest MAPEs wins the rat
race.

5.1TheTimeSeriesoftheEstimatedParameters
First, we discuss the results for the grid search, and subsequently we comment on the parameter
estimatesfortheOLSapproachwheretheshapeparameterisfixed.Finally,wepresenttheparameters
forthegridsearchusingtheconditionalridgeregression.

5.1.1Thegridsearch
Figure6graphicallyrepresentsthetimeseriesof
0
,
1
,
2
and(
0
+
1
)estimates,basedonagridsearch
usingOLS.Atsomepointsintime,thethreecoefficientsareclearlyquiteerratic.Moreover,forthelong
term interest rate level
0
, some negative values are obtained, thereby clearly violating any economic
intuition.Theshortendofthetermstructure,denotedby(
0
+
1
),isalwayspositive.Thisisexplained
byhighlynegativecorrelationbetweenthetimeseriesof
0
and
1
estimates.ForAugust21,2007e.g.
the high
0
coefficient (9.737) is accompanied with a low
0
coefficient (5.096) which leads to an
estimateoftheshortrateof5.477%.

17

Figure6:TimeSeriesofEstimatedParameterswiththeGridSearchBasedonOLS

Note:Thisfigureplotsthetimeseriesof
0
,
1
,
2
and(
0
+
1
)estimatesoftheNelsonSiegelmodelonEurospotratesbased
onagridsearchusingOLSovertheperiodfromJanuary4,1999toMay12,2009.

Inanattempttounderstandthesourceoftheerratictimeseriesbehaviour,wereportthehistogramof
the estimated shape parameters (Figure 7). The variation of the shape parameter estimates indicates
that this parameter cannot be assumed constant over time. This confirms the visual inspection of the
timeseriesplotofour dataset(Figure 5)whichrevealed thattheshapeand theposition ofthehumps
changedovertime.Morethan55%oftheestimatedshapeparametersarelocatedwithintherangeof0
to2,approximately20%withintherangeof2to4,andalittlemorethan19%withintherangeof8to
01/15/00 05/29/01 10/11/02 02/23/04 07/07/05 11/19/06 04/02/08
-5
0
5
10
15
20
25
21-Aug-2007
9.737
Date

0
(Grid Search Based on OLS)
01/15/00 05/29/01 10/11/02 02/23/04 07/07/05 11/19/06 04/02/08
-20
-15
-10
-5
0
5
21-Aug-2007
-5.095
Date

1
(Grid Search Based on OLS)
01/15/00 05/29/01 10/11/02 02/23/04 07/07/05 11/19/06 04/02/08
-30
-25
-20
-15
-10
-5
0
5
10
15
21-Aug-2007
-7.339
Date

2
(Grid Search Based on OLS)
01/15/00 05/29/01 10/11/02 02/23/04 07/07/05 11/19/06 04/02/08
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
6
Date

0
+
1
(Grid Search Based on OLS)

10. For th
boundof

Note:Thisf
grid search
performedw

There are
bound of
hump/tro

4
We perfor
The shape
searchinter
he shape par
thesearchin
Figure7:His
figureshowsthe
based on OLS o
withtheshapep
e two explana
f the search
ough.Bothsit

rmed grid search
parameters that
rvalwhenthisup
ameters with
ntervali.e.at
stogramofO
ehistogramthe
over the sample
parameterrangi
ations for the
interval: the
uationsoccu

h with the shap
t are estimated
pperboundis20
hin the range
10.
4

OptimalShape
estimatedshap
period from Ja
ngfrom0to10
e relatively la
e absence o
rinourdatas
e parameter ran
to be at the u
0or30.
18
e of 8 to 10,
eParameters
peparameters
nuary 4, 1999 to
.
rge amount
f a hump/tr
setasinshow
nging from 0 to
pper bound (e.g
472 out of 5
sUsingGridS
oftheNelsonS
o May 12, 2009
of shape par
rough or the
wninFigure8
10, 0 to 20 (no
g. 10) are also e
506 are estim
SearchBased

Siegelmodelon
9, totaling to 264
rameter estim
e presence o
8.
ot reported) or 0
estimated at th
mated at the u
donOLS
nEurospotrate
44 days. Grid se
mates at the u
of more than
0 to 30 (not rep
he upper bound
upper
susing
earch is
upper
n one
ported).
of the

Figure8
Pa
Note:Thisf
parameters
cleareviden
flexibleeno

Figure 8
estimate
ispresent
to be at t
humpatt
2007.Her
inspection
optimal s
boundsha
from the
potential
moreapp
8:TheTermS
anelA(Date
figuredepictsth
based on grid s
nceofhump/tro
ughtocapturet
plots the ter
attheupper
ted.Sincethe
the upper bo
the veryend
rethetermst
nshowsthat
hape parame
apeparamete
NelsonSieg
multicollinea
propriatecand
tructureofS
:May20,200
hetermstructur
search in both P
ough.InPanelB
theshapeofthis
m structure
boundofthe
etermstructu
ound of the s
ofthe term
tructureisto
onehumpis
eter is compu
erestimates.
el specificati
arity. In the l
didatetodesc
potRateson
04)
eofspotrateso
Panel A and Pan
thetermstructu
stermstructure
on May 20,
esearchinter
uredoesnot
search interv
structure.Fig
oocomplicate
notsufficien
uted to be 10
Intheforme
on to fit the
atter case, a
cribetheterm
19
May20,200
Pane
onMay20,2004
nel B are binding
urehasonehum
e.
2004 and on
rval.Inpanel
showahump
al. The optim
gure 8,Panel
edtobedescr
nttocloselyf
0. Both exam
ercase,thecu
e curve, wit
more flexibl
mstructure.
04(PanelA)a
elB(Date:Au
4(PanelA)and
g at 10. In Pane
mpandonetrou
n August 21,
AofFigure8
p/trough,the
mization proc
lB depictsth
ribedbythe
fitthetermst
mples illustrat
urvaturecom
h the additio
le model suc
andAugust2
ugust21,200
August21,200
el A the term str
gh,buttheNels
2007 with a
8,thesituatio
eshapeparam
cedure theref
he termstruc
NelsonSiege
tructureont
te problems
mponentcans
onal benefit
h as Svensso
1,2007(Pane
07)
07(PanelB).The
ructure does no
sonSiegelmode
a shape param
onofMay20,
meterisestim
fore estimate
cture ofAugu
elmodel.Gra
hisday.Agai
resulting in u
simplybedro
of eliminati
on (1994) wil
elB)

eshape
ot show
elisnot
meter
,2004
mated
es the
st21,
phical
n,the
upper
opped
ng of
l be a
20

Figure9:LongTermSpotRateEstimatesandtheirStandardErrorsGridSearch

Note:Thisfigureplotsthelongtermspotrateestimates(solidline)andtheirstandarderrors(dashedline)basedongridsearch
overthesampleperiodfromJanuary4,1999toMay12,2009,totalingto2644days.TheerraticbehaviouroftheNelsonSiegel
modelbasedongridsearchisillustrated.

Grid search not only results in erratic time series of factor estimates, the precision of the estimates is
alsoverytimevarying.Figure9redraws(asanexample)theestimatesofthelongtermspotrate(solid
line)anditsstandarderrors(dashedline).Whereasthestandarderrorsaresmallattimes,manyperiods
ofturbulenceareshowninwhichthestandarderrorsbecome1%andmore!

5.1.2TheOLSwithfixedshapeparameter
Figure10plotsthetimeseriesoftheestimatedparametersconditionalonafixedshapeparameter.In
the left column we present the estimates using a fixed shape parameter of 1.37 (as in Diebold and Li
(2006)), whereas on the right side those with a fixed shape parameter of 3 (as in Fabozzi et al. (2005))
are depicted. Generally, the time series of the estimates are not as volatile as those based on the grid
search and the time series look smoothed. The higher shape parameter, however, results in a less
smoothed time series of the estimated
0
,
1
and
2
. The longterm interest rate level implied by the
NelsonSiegel model is always positive, and the short end does not show negative interest rate
01/01/00 01/01/02 01/01/04 01/01/06 01/01/08
0
5
10
15
20
25

0

(
%
)

01/01/00 01/01/02 01/01/04 01/01/06 01/01/08
0
1
2
3
4
5
6
7
S
t
a
n
d
a
r
d

E
r
r
o
r
(
%
)

0
Standard Error
21

estimates either. However, the economic interpretation of the coefficients as factors, remains
problematic.Atthestartofourseriese.g.,thelongtermrateisestimatedasbeing4.53%(=1.37)and
5.74%(=3)whereasthe30yearswapratewas4.99%.So,whichshapeparametershouldweconsider
tobethemostappropriate?
Theprecisionoftheestimatesimprovesdramaticallycomparedtothegridsearch.Figure11showsthe
standarderrorsforthelongtermrateusing=1.37.Duringthefinancialcrisis,thestandarderrorwent
uptomorethan35basispoints.Thisisaseriousimprovement,comparedtothestandarderrorsofthe
grid search, where the standard errors went up to 500 basis points and more. Whether the shape
parameter canbestbefixedto1.37orto3,however,remainsanopenquestion.Especiallytheresults
for
2
arequitedifferentforbothchoicesinshapeparameter,ascanbeseeninFigure10.Ourestimates
also suggest that the economic characteristics of the time series of the estimated coefficients may be
quitedifferent.RecallthattheNelsonSiegelmodelcanbeinterpretedintermsofathreefactormodel,
the estimated coefficients being weights. Taking the variability of the shape parameter estimates we
obtained in our grid search into account, it can be questioned whether the time variation in can be
ignoredatall!

22

Figure10:TimeSeriesofEstimatedParameterswithFixedShapeParameters

Note:Thisfigureplotsthetimeseriesof
0
,
1
,
2
and(
0
+
1
)estimatesoftheNelsonSiegelmodelonEurospotratesbased
onfixedshapeparametersof1.37(PanelA)and3(PanelB).ThesampleperiodrunsfromJanuary4,1999toMay12,2009.
01/15/00 05/29/01 10/11/02 02/23/04 07/07/05 11/19/06 04/02/08
0
1
2
3
4
5
6
7
8
9
10
Date

0
(Diebold and Li)
01/15/0005/29/01 10/11/0202/23/04 07/07/0511/19/06 04/02/08
0
1
2
3
4
5
6
7
8
9
10
Date

0
(Fabozzi et al)
01/15/00 05/29/01 10/11/02 02/23/04 07/07/05 11/19/06 04/02/08
-5
-4
-3
-2
-1
0
1
2
3
4
5
Date

1
(Diebold and Li)
01/15/0005/29/01 10/11/0202/23/04 07/07/0511/19/06 04/02/08
-5
-4
-3
-2
-1
0
1
2
3
4
5
Date

1
(Fabozzi et al)
01/15/00 05/29/01 10/11/02 02/23/04 07/07/05 11/19/06 04/02/08
-10
-8
-6
-4
-2
0
2
4
6
8
10
Date

2
(Diebold and Li)
01/15/0005/29/01 10/11/0202/23/04 07/07/0511/19/06 04/02/08
-10
-8
-6
-4
-2
0
2
4
6
8
10
Date

2
(Fabozzi et al)
01/15/00 05/29/01 10/11/02 02/23/04 07/07/05 11/19/06 04/02/08
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
6
Date

0
+
1
(Diebold and Li)
01/15/0005/29/01 10/11/0202/23/04 07/07/0511/19/06 04/02/08
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
6
Date

0
+
1
(Fabozzi et al)
23

Figure11:EstimatesoftheLongTermRateandtheirStandardErrors(=1.37)

Note: This figure depicts the estimates of the long term rate (
0
) and their standard errors (Standard Error) based on a fixed
shapeparameterof1.37overthesampleperiodfromJanuary4,1999toMay12,2009.

5.1.3Gridsearchwithconditionalridgeregression
Adrawbackoftheridgeregressiontechniqueisthelackofstandarderrors,whichprohibitsanykindof
significance tests on the estimated coefficients (DeMaris (2004)). However, we can (visually) examine
thestabilityofthetimeseriesestimates.Figure12againconfirmsthatthetimeseriesof
0
,conditional
on a fixed shape parameter of 3, almost perfectly coincides with the grid search
0
, time series. A low
shapeparametersmoothestheextremejumpsinthecoefficientsseriesalmostcompletely,whereasthe
ridgeregressiontakesamiddleposition.Whenevercanbefreelyestimated(i.e.whenissufficiently
low), no multicollinearity problems occur and the ridge regression is redundant. Whenever the
correlation between the regressors exceeds our threshold, the ridge regression has a moderate
smoothing effect. However, the variation in the coefficients, e.g.
0
in Figure 12 retains the strains put
onthetermstructure.

01/01/00 01/01/02 01/01/04 01/01/06 01/01/08

0
1
2
3
4
5
6
7

0

(
%
)

01/01/00 01/01/02 01/01/04 01/01/06 01/01/08
0
0.1
0.2
0.3
0.4
S
t
a
n
d
a
r
d

E
r
r
o
r
(
%
)

0
Standard Error

Note: This f
regression,
periodfrom

Figure13
therights
Theestim
There are
leveljump
reached i
Ridge reg
longterm
shortend

Figure12:Th
figure plots the
fixed shape par
mJanuary4,1999
showstheti
sidetheresul
matesfromth
e no negative
pedupfrom
ts peak of 8
ression impro
minterestrate
oftheterms
heEstimated
estimated long
rameter of 1.37
9toMay12,200
meseriesof
ltsfromboth
heridgeregre
e values in th
4.80%inJune
.99% in Octo
oves the stab
elevelcompl
structureaga
LongTermR
g term rates bas
7 (Diebold and L
09.
alltheestim
thegridsear
essionaremo
e longterm
e2007to5.8
ober 2008. Af
bility of the e
lieswiththe
ainisalwaysp
24
RateBasedon
sed on the follo
Li), and fixed sh
atedcoefficie
rchbasedon
orestablecom
interest rate
85%inAugust
fterwards the
estimates calc
economicint
positive,cons
nAlternative
owing estimation
hape parameter
entsusingth
OLSandther
mparedtoth
level anymo
t2007,then8
e longterm i
culated by th
tuitionbehind
sistentwithre
eEstimationM
n methods: the
of 3 (Fabozzi e
eridgeregre
ridgeregress
heresultsfro
re. The long
8.14%inMar
interest rate
he grid search
dtheNelson
eality.
Methods

grid search, the

et al.) over the s
ession,where
ionareplotte
mthegridse
term interes
rch2008,and
level went d
h. And the po
Siegelmode
e ridge
sample
eason
ed.
earch.
st rate
dthen
down.
ositive
el.The
25

Figure13:EstimatedParameterswiththeRidgeRegressionandGridSearch

Note: This figure depicts the estimated parameters of the NelsonSiegel model based on both grid search (line) and ridge
regression(dot).
0
representsthelongterminterestratelevelimpliedbytheNelsonSiegelmodel.
0
+
1
representstheshort
terminterestratewhentimetomaturityiszero.

Inordertomeasurethestabilityofthetimeseriesofestimatedcoefficientsmoreformally,wecompute
thestandarddeviationoftheirfirstdifferences(Table3).Wenoticethatridgeregressionshavealower
volatility for all three parameters. Moreover, an Ftest at the 95% confidence interval shows that the
standard deviations of the ridge regression coefficients changes are significantly lower than those
obtainedthroughthegridsearch.Theridgeregression,hence,cansubstantiallyreducetheinstabilityof
the estimates in the grid search. Compared with the fixed shape parameter procedures, the ridge
regression allows the shape parameter to vary over time. Whether or not this is a desirable property
froman economic pointofview,stillhastobeseen.Therefore, weexamine theinandoutofsample
predictionperformanceofthevariousmethods.

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26

Table3:TheStandardDeviationsofFirstDifferencesintheEstimates(inPercentage)
GridSearch RidgeRegression =1.37 =3

0
0.602 0.141 0.058 0.079

1
0.584 0.138 0.068 0.080

2
1.594 1.106 0.126 0.225
Note:Thistableshowsthestandarddeviationsofthefirstorderchangesinthetimeseriesoftheestimatedparameters.The
datasetusedtoestimatetheparametersiscomposedof1week,1to12month,and1to10yearspotrates.AnFtestata95%
confidenceintervalshowsthatallthestandarddeviationsaresignificantlydifferentfromeachother.

5.2Insampleperformance
In order to examine the insample performance, we compute the mean absolute errors between the
predicted and the bootstrapped spot rate (Table 4). To test whether MAPEs are statistically different
fromeachother,wecompute:

1 2
,
Method Method
= 1 r r r r

i (5.1)
where r

is the vector of empirical rates for a certain time to maturity, 1 is a vector of ones,
1 Method
r

and
2 Method
r

are the vectors of estimated spot rates using different methods (e.g. grid, ridge, Diebold and Li
(DL) and Fabozzi et al. (FMP)). If the estimated coefficient

is significantly negative, then we consider

Method1tobebetterthanMethod2.TheNeweyWestcorrectionisusedtoremoveserialcorrelation
fromtheresiduals.
AlthoughtheoverallMAPEisminimizedbyconstructionfortheGridSearch,theinsampleMAPEsper
maturity show how the fixed shape parameter methods perform compared to the ridge regression
technique.TheMAPEofFMP(DL)isfor13(9)outofthe22maturitiesthehighest.For8outofthe22
maturities,theridgeregressiongeneratesthelowestMAPE,butitneverproducesthehighestMAPEs.
The grid search is for more than half of the maturities the MAPE minimizing method. The insample
MAPEs reveal the limitations of reducing the model flexibility by fixing the shape parameters. Ridge
regressionoutperformsthesetwomethodsconvincingly.

27

Table4:InSampleMeanAbsolutePredictionErrors
Maturity Grid Ridge DL(=1.37) FMP(=3)
1Week 0.113 0.103* 0.130 0.170+
1Month 0.067 0.059* 0.076 0.114+
2Months 0.035 0.031* 0.033 0.062+
3Months 0.031* 0.035 0.034 0.042+
4Months 0.030* 0.034 0.036+ 0.034
5Months 0.031* 0.035 0.039+ 0.036
6Months 0.033* 0.035 0.043 0.047+
7Months 0.033* 0.034 0.043 0.055+
8Months 0.034* 0.034 0.044 0.063+
9Months 0.035 0.035* 0.045 0.070+
10Months 0.036 0.035* 0.045 0.075+
11Months 0.038 0.037* 0.045 0.079+
12Months 0.041 0.039* 0.046 0.083+
2Years 0.055* 0.068 0.073+ 0.057
3Years 0.048* 0.065 0.077+ 0.055
4Years 0.033* 0.052 0.072+ 0.065
5Years 0.028* 0.044 0.065+ 0.061
6Years 0.024* 0.030 0.046 0.047+
7Years 0.015 0.013* 0.017 0.026+
8Years 0.013 0.018 0.022 0.008*
9Years 0.020* 0.037 0.054+ 0.034
10Years 0.033* 0.055 0.083+ 0.066
Note: Insample mean absolute errors between produced data from the NelsonSiegel and empirical data are presented. The
datasetusedtoestimatetheparametersiscomposedby1week,1to12month,and1to10yearspotrates.*Thisapproach
yieldsthelowestMAPEforthistimetomaturity.+ThisapproachyieldsthehighestMAPEforthistimetomaturity.Exceptthe
followingpairs,alltheMAPEsaresignificantlydifferentfromeachother(at95%confidenceinterval)basedonthettestwith
NeweyWestcorrectedstandarderrors:2month:gridandDL;3month:ridgeandDL;4month:ridgeandFMP;5month:ridge
andFMP;2year:gridandFMP;5year:DLandFMP;6year:DLandFMP;9year:ridgeandFMP.Themeanabsoluteerrorsare
testedusingEquation5.1.

5.3Outofsampleperformance
SincetheridgeregressionaddsasmallbiastotheOLS,weconsideranoutofsampleperformancetest
superior in order to judge the appropriateness of the various estimation methods. If we denote

r r

= as the residual between the spot rate r

observed from the market and the estimated spot

ratebytheNelsonSiegelmodel

foracertaintimetomaturity,thebiasisestimatedastheaverage
of the

s. The outofsample bias on each day is measured by averaging the residuals after fitting the
28

EONIA, 20, 25 and 30year swap rates using four methods. Table 5 clearly shows that the bias
introducedintheridgeregressiondoesnotaffectthebiasintheforecastedspotratesinamaterialway
comparedtotheotherestimationmethods.
Table5:OutofSampleBias
Grid Ridge

DL(=1.37) FMP(=3)
Mean 0.070 4.00E4 0.099 0.089
Std.Dev. 0.384 0.152 0.102 0.214
Minimum 2.216 0.925 0.356 0.820
Maximum 0.703 0.369 0.393 0.558
Note:Thebiasisexpressedinpercentage.ThesampleperiodrunsfromJanuary4,1999toMay12,2009,totalingto2644days
for which the outofsample estimation bias is measured. The outofsample bias on each day is measured by averaging the
residuals after fitting the EONIA, 20, 25 and 30year swap rates using four methods. All the biases are significantly different
fromeachotherbasedonattestwithNeweyWestcorrectedstandarderrors.

To investigate the ability of these four approaches to forecast the long and short end of the term
structure,wewillcomparetheestimatedratestotheEONIA,the20,25and30yearEuroswaprates.
TheMAPEwillagainbeourcriterion.
Theoretically speaking,theestimated
0
+
1
representstheshortendof the termstructure.However,
theEONIAratesaretheshortesttermspotratesthatcanbeobservedinthemarket.Consequently,ifa
model canpredictthe EONIArateswiththehighestaccuracy,it willbesuperiorinpredictingtheshort
endoftheyieldcurve.
TheestimatedEONIAratesarecalculatedbypluggingtimetomaturity=1/365

intoEquation2.3along
with the estimated parameters for all four methodologies. Afterwards, the differences between the
empirical and the estimated rates are examined following the same procedure as for the insample
MAPEstests.
Inaddition, wealsocheckwhichmodelcan bestfitthelongtermendofthetermstructure.However,
longtermspotratesarenotdirectlyobservableinthemarketeither.Moreover,duetothelackofswap
rates for certain times to maturity (e.g. 11 or 29year swap rate) to bootstrap the longterm spot rate
(e.g.30yearspotrate),wewillusethefollowingproceduretochecktheforecastingability:
1. CombiningEquation2.3and3.4,wecalculatetheestimatedswapratesusing
29

( )
( )
( )
1
1 1
,
1
1
j
j
R
S
R j

=
+

=
+

(5.2)
where=2,...,30arethetimestomaturity,
( )
( )
1
r
R e

=

is the estimated year annually compounded spot rate, ( )

r is the estimated continuously

compoundedspotrate,and
( )

S istheestimatedswaprate.
2. We calculate and test the MAPEs between the empirical and the estimated swap rates using
thesameprocedureaspreviously.
TheresultsaresummarizedinTable6.TheridgeregressionalwaysyieldsthestatisticallylowestMAPEs.
The restriction DL and FMP put on the shape parameter makes them underperform compared to both
the ridge and the OLS regression. Moreover, the ridge regression has lower prediction errors when
predictingthelongend,comparedtotheshortendofthetermstructure.
Table6:OutofSampleMeanAbsolutePredictionErrors
Maturity Grid Ridge DL(=1.37) FMP(=3)
OvernightEONIA 0.254 0.246* 0.287+ 0.278
20yearswaprate 0.201 0.142* 0.234+ 0.221
25yearswaprate 0.262 0.150* 0.236 0.268+
30yearswaprate 0.304 0.152* 0.227 0.307+
Note:OutofsampleMAPEsbetweenproduceddatafromNelsonSiegelandempiricaldataarepresented.Thedatasetusedto
estimate the parameters is composed by 1week, 1 to 12month, and 1 to 10year spot rates. * This approach yields the
lowestMAPEforthistimetomaturity.+ThisapproachyieldsthehighestMAPEforthistimetomaturity.Exceptthefollowing
pairs, all the MAPEs are significantly different from each other (at 95% confidence interval) based on the ttest with Newey
Westcorrectiononstandarderrors:20year:gridandFMP,DLandFMP;25year:DLandFMP,gridandFMP;30year:gridand
FMP.ThemeanabsoluteerrorsaretestedusingEquation5.1.
The superiority of the ridge regression procedure is not only statistically significant. Looking at the
MAPEsforthe30yearswaprate,theMAPEsareloweredwith7to15basispoints.Ontheshortend,
thegainismoremoderate,upto4basispoints.

30

5.4Robustnesscheckontheforecastingability
We consider two robustness checks to confirm the outperformance of the conditional ridge regression
procedure we propose. First, we want to verify whether or not our results are mainly driven by the
20082009financialcrisiswhichispartofourdataset.Second,wehaveshownthatthemulticollinearity
problemisseverelyaffectedbythechoiceofthematurityvector.Wewillexaminewhetherourresults
arerobusttothechoiceofadifferentmaturityvector.
5.4.1Theimpactofthefinancialcrisis
AsseeninFigure13,thefinancialcrisishashadasubstantialimpactonparameterestimation.Wethus
divide our dataset into two subsets, the precrisis period from January 4, 1999 to July 2, 2007 (2169
days),andthecrisisperiodfromJuly3,2007toMay12,2009(475days).Theoutofsamplepredicting
powerofallfourapproaches(Grid,Ridge,DLandFMP)ispresentedinTable7andTable8.
A ttest between the precrisis and crisis period MAPEs at 95% confidence level shows that during the
financialcrisisthepredictingabilityofallfourmethodsissignificantlylowered.Thepredictingabilityof
the grid search drops dramatically for both the short and the long end of the term structure, while for
theothermethodologies,thefinancialcrisishasmoreimpactontheshortendthanonthelongend.
Nevertheless, the ridge regression performs consistently in both periods, while the grid search clearly
does not. During the financial crisis the grid search predictions are worst for the longend of the yield
curvewhereasintheprecrisisperiod,theFMPmodelisworstforthesematurities.
Theresultsshowninthesetwotablesagainconfirmourpreviousfindingsthattheridgeregressionhas
superiorpredictabilityinforecastingbothendsoftheyieldcurve.

31

Table7:OutofSampleMeanAbsolutePredictionErrors(PrecrisisPeriod)
Maturity Grid Ridge DL(=1.37) FMP(=3)
OvernightEONIA 0.161 0.161* 0.195+ 0.169
20yearswaprate 0.142 0.137* 0.206 0.217+
25yearswaprate 0.161 0.140* 0.218 0.260+
30yearswaprate 0.169 0.131* 0.211 0.296+
Note: Outofsample MAPEs between produced data from NelsonSiegel and empirical data are presented for the precrisis
periodfromJanuary4,1999toJuly2,2007(2169days).Thedatasetusedtoestimatetheparametersiscomposedby1week,
1 12 month, and 1 to 10year spot rates. * This approach yields the lowest MAPE for this time to maturity. + This approach
yieldsthehighestMAPEforthistimetomaturity.Exceptthefollowingpairs,alltheMAPEsaresignificantlydifferentfromeach
otherbasedonthettestwithNeweyWestcorrectiononstandarderrors:EONIA:gridandridge,gridandFMP,ridgeandFMP;
20year:gridandridge,DLandFMP.

Table8:OutofSampleMeanAbsolutePredictionErrors(CrisisPeriod)
Maturity Grid Ridge DL(=1.37) FMP(=3)
OvernightEONIA 0.676 0.635* 0.704 0.775+
20yearswaprate 0.470+ 0.165* 0.363 0.240
25yearswaprate 0.721+ 0.198* 0.317 0.306
30yearswaprate 0.919+ 0.251* 0.296 0.361
Note:OutofsampleMAPEsbetweenproduceddatafromNelsonSiegelandempiricaldataarepresentedforthecrisisperiod
from July 3, 2007 to August 12, 2009 (475 days). The dataset used to estimate the parameters is composed by 1week, 1 12
month,and1to10yearspotrates.*ThisapproachyieldsthelowestMAPEforthistimeto maturity.+Thisapproachyields
thehighestMAPEforthistimetomaturity.Exceptthefollowingpairs,alltheMAPEsaresignificantlydifferentfromeachother
basedonthettestwithNeweyWestcorrectiononstandarderrors:EONIA:gridandDL;20year:gridandDL;25year:DLand
FMP;30year:ridgeandDL,DLandFMP.

5.4.2ADifferentMaturityVector
Inordertotesttherobustnessofour results,weestimatetheyield curvesagain usingonly1week,6
month,1to10yearspotrates.Theresults,showninTable9,alsoconfirmourpreviousfindingsthatthe
ridgeregressionhassuperiorpredictabilityinforecastingbothendsfortheyieldcurve.However,unlike
fortheotherdataset,nowthepredictabilityofFMPon25and30yearswapratesisnottheworst,but
the grid search is. Here the correlation between the slope and hump factor using the DLestimation
recipe is 0.35 instead of 0.55. The highest MAPEs for the 25 and 30year swap rates obtained using
thegridsearchbasedontheOLSregression,canbeblamedontheinstableestimates.
32

Table9:OutofSampleMeanAbsolutePredictionErrors
Maturity Grid Ridge DL(=1.37) FMP(=3)
OvernightEONIA 0.293 0.217* 0.255+ 0.243
20yearswaprate 0.171 0.128* 0.205+ 0.179
25yearswaprate 0.226+ 0.140* 0.207 0.222
30yearswaprate 0.266+ 0.147* 0.200 0.259
Note:OutofsampleMAPEsbetweenproduceddatafromNelsonSiegelandempiricaldataarepresented.Thedatasetusedto
estimate the parameters is composed by 1week, 6month, and 1 to 10year spot rates. * This approach yields the lowest
MAPEforthistimetomaturity.+ThisapproachyieldsthehighestMAPEforthistimetomaturity.Exceptthefollowingpairs,all
the MAPEs are significantly different from each other based on the ttest with NeweyWest correction on standard errors:
EONIA:gridandDL;20year:gridandFMP;25year:gridandDL,gridandFMP,DLandFMP;30year:gridandDL.

Again, we test the influence of the financial crisis on the performance of the proposed methods, this
timeonourlimitedsample.Theresultsfromthisanalysiscomparingestimatesoftheprecrisisandcrisis
periodaresummarizedinTable10andTable11.
At the 95% confidence level, a ttest between the precrisis and crisis period MAPEs shows that the
performanceofthefourmethodsbehavessimilartothatoftheotherdataset.Thehighvolatilityofthe
estimatesinthegridsearchmakesitsperformancedropsubstantiallyduringthefinancialcrisis.
The ridge regression always has the highest predicting ability except for the 30year swap rate during
thecrisisperiod,wheretheDLhasthehighestpredictingability.However,thedifferencebetweenthese
twomethodsforthe30yearswaprateduringthefinancialcrisisisnotstatisticallysignificant.
Table10:OutofSampleMeanAbsolutePredictionErrors(PrecrisisPeriod)
Maturity Grid Ridge DL(=1.37) FMP(=3)
OvernightEONIA 0.216+ 0.156* 0.186 0.160
20yearswaprate 0.128 0.120* 0.191+ 0.173
25yearswaprate 0.150 0.124* 0.201 0.209+
30yearswaprate 0.161 0.121* 0.192 0.242+
Note: Outofsample MAPEs between produced data from NelsonSiegel and empirical data are presented for the precrisis
periodfromJanuary4,1999toJuly2,2007(2169days).Thedatasetusedtoestimatetheparametersiscomposedby1week,
6month,and1to10yearspotrates.*ThisapproachyieldsthelowestMAPEforthistimetomaturity.+Thisapproachyields
thehighestMAPEforthistimetomaturity.Exceptthefollowingpairs,alltheMAPEsaresignificantlydifferentfromeachother
basedonthettestwithNeweyWestcorrectiononstandarderrors:25year:DLandFMP.

33

Table11:OutofSampleMeanAbsolutePredictionErrors(CrisisPeriod)
Maturity Grid Ridge DL(=1.37) FMP(=3)
OvernightEONIA 0.642+ 0.499* 0.571 0.624
20yearswaprate 0.365+ 0.164* 0.268 0.205
25yearswaprate 0.578+ 0.213* 0.236 0.280
30yearswaprate 0.749+ 0.264 0.236* 0.337
Note:OutofsampleMAPEsbetweenproduceddatafromNelsonSiegelandempiricaldataarepresentedforthecrisisperiod
fromJuly3,2007toAugust12,2009(475days).Thedatasetusedtoestimatetheparametersiscomposedby1week,6month,
and 1 to 10year spot rates. * This approach yields the lowest MAPE for this time to maturity. + This approach yields the
highest MAPE for this time to maturity. Except the following pairs, all the MAPEs are significantly different from each other
basedonthettestwithNeweyWestcorrectiononstandarderrors:EONIA:gridandDL,gridandFMP;25year:ridgeandDL,
DLandFMP;30year:ridgeandFMP.

One thing worth mentioning is that for the alternative dataset, not only the long end of the term
structurebasedonthegridsearchisextremelyvolatileandsometimesnegative,soistheshortendof
thetermstructure,asshowninFigure14.Thisagainshowsthatthegridsearchisverysensitivetothe
underlyingdataset.
Figure14:TheShortEndoftheTermStructurebytheGridSearchBasedonOLS

Note:ThisfigureplotstheshortendofthetermstructureimpliedbythegridsearchedbasedonOLSoverthesampleperiod
fromJanuary4,1999toMay12,2009,totalingto2644days.

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6.Conclusion
Many researchers have reported problems in estimating the NelsonSiegel (1987) model. We have
shown that multicollinearity between the slope and hump factor are causing both instability of the
regressioncoefficientsovertimeandlargestandarderrorsonthecoefficients.Totempertheestimation
problems, we apply ridge regression technique, whenever the grid search based estimate of the shape
parameter results in highly correlated slope and hump factors. For euro spot rate curves, over the
period1992009,wecomparethegridsearchestimatesoriginallyproposed byNelsonandSiegel to
our ridge regression estimates. The Diebold and Li (2006) and the Fabozzi et al. (2005) estimates were
alsocalculatedasabenchmark.
The insample comparison shows that the grid search produces erratic time series estimates which
sometimesviolatetheeconomicintuitionbehindtheNelsonSiegelmodel.Thedistributionofthefreely
estimated shape parameters and the insample fitting errors reveal the limitation of the use of a fixed
shapeparameter.Theoutofsamplepredictabilityatthetwoendsofthetermstructureshowsthatthe
ridge regression always produces the lowest mean absolute prediction errors. For the long end of the
term structure, the economic gain in the MAPE mounted up to 15 basis points. For the short end, the
differencesinMAPEswerestatisticallysignificantbuteconomicallysmaller.
Robustnesschecksshowthattheridgeregressionperformsrobustlyandconsistentlybetterindifferent
economic environments (precrisis and crisis period) and with different choices of the maturity vector
(i.e.thesetoffinancialinstrumentsusedtobootstraptheyieldcurve).
Basedonourfindings,fixingtheshapeparameterinordertoavoidmulticollinearity,isastatisticaltrick
thatdoesreducethecorrelationbetweentheregressorswhenthefixingisjudiciallychosen.Ithowever
ignores the bare fact that in practice, term structures do take all kind of (humpy) shapes and that the
hump simply is not fixed over the time to maturity spectrum. The loss in flexibility comes at a severe
price especially for the predictions of long term spot rates. This paper advances a procedure based on
ridgeregressiontoreducethepredictionerrorssignificantly.

35

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