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Analyzing and forecasting the Chinese term structure of interest rates using functional principal component analysis

Pan Feng (Antai College of Economics and Management, Shanghai Jiao Tong University, Shanghai, China)
Junhui Qian (Antai College of Economics and Management, Shanghai Jiao Tong University, Shanghai, China)

China Finance Review International

ISSN: 2044-1398

Article publication date: 23 April 2018

Issue publication date: 30 July 2018

434

Abstract

Purpose

The purpose of this paper is to analyze and forecast the Chinese term structure of interest rates using functional principal component analysis (FPCA).

Design/methodology/approach

The authors propose an FPCA-K model using FPCA. The forecasting of the yield curve is based on modeling functional principal component (FPC) scores as standard scalar time series models. The authors evaluate the out-of-sample forecast performance using the root mean square and mean absolute errors.

Findings

Monthly yield data from January 2002 to December 2016 are used in this paper. The authors find that in the full sample, the first two FPCs account for 98.68 percent of the total variation in the yield curve. The authors then construct an FPCA-K model using the leading principal components. The authors find that the FPCA-K model compares favorably with the functional signal plus noise model, the dynamic Nelson-Siegel models and the random walk model in the out-of-sample forecasting.

Practical implications

The authors propose a functional approach to analyzing and forecasting the yield curve, which effectively utilizes the smoothness assumption and conveniently addresses the missing-data issue.

Originality/value

To the best knowledge, the authors are the first to use FPCA in the modeling and forecasting of yield curves.

Keywords

Acknowledgements

The authors would like to thank three anonymous referees for their helpful comments. The authors are also grateful for the financial support from the Natural Science Foundation of China (Grant No. 71673183).

Citation

Feng, P. and Qian, J. (2018), "Analyzing and forecasting the Chinese term structure of interest rates using functional principal component analysis", China Finance Review International, Vol. 8 No. 3, pp. 275-296. https://doi.org/10.1108/CFRI-06-2017-0065

Publisher

:

Emerald Publishing Limited

Copyright © 2018, Emerald Publishing Limited

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