Modelling Australian Bank Bill Rates : a Kalman Filter Approach

This paper examines the applicability of the Kalman Filter technique to forecast future spot interest rates, based upon the expectation hypothesis of the term structure of interest rates, in the Australian bank bill market. In this approach, regression estimates are based on the last period's estimate together with data from the current period. In contrast to constant parameter models, this allows effective use of information underlying the process driving the evolution of the parameters. For the period tested, forecasting accuracy of such a time-varying parameter model shows marked improvement over a constant parameter model. Acknowledgements: I am particularly indebted to one anonymous referee for very insightful comments on the earlier versions of the paper, and would like to thank the editor, Rob Brown, for helpful suggestions. Australian Bank Bill Rate: Kalman Filter Approach