No Arbitrage Priors, Drifting Volatilities, and the Term Structure of Interest Rates

In this paper we propose a method to produce density forecasts of the term structure of government bond yields which takes into account (i) the possible mispeci…cation of an underlying Gaussian A¢ ne Term Structure Model (GATSM) and (ii) the time varying volatility of interest rates. In order to do so we derive a Bayesian prior from a GATSM and use it to estimate the coe¢ cients of a BVAR for the term structure, specifying a common, multiplicative, time varying volatility for the VAR disturbances. Results based on U.S. data show that this method signi…cantly improves the precision of point and density forecasts of the term structure. The views expressed herein are solely those of the authors and do not necessarily re‡ect the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System. We would like to thank ............ The usual disclaimers apply.