Estimation and inference in the yield curve model with an instantaneous error term

Many variations exist of yield curve modeling based on the exponential components framework, but most do not consider the generating process of the error term. In this paper, we propose a method of yield curve estimation using an instantaneous error term generated with a standard Brownian motion. First, we add an instantaneous error term to Nelson and Siegel’s instantaneous forward rate model [C.R. Nelson, A.F. Siegel, Parsimonious modeling of yield curves, Journal of Business 60 (1987) 473–489]. Second, after differencing multiperiod spot rate models transformed using Nelson and Siegel’s instantaneous forward rate model [C.R. Nelson, A.F. Siegel, Parsimonious modeling of yield curves, Journal of Business 60 (1987) 473–489], we obtain a model with serially uncorrelated error terms because of independent increment properties of Brownian motion. As the error term in this model is heteroskedastic and not serially correlated, we can apply weighted least squares estimation techniques. That is, this specification of the error term does not lead to incorrect estimation methods. In an empirical analysis, we compare the instantaneous forward rate curves estimated by the proposed method and an existing method. We find that the shape from the proposed estimation equation differ from the latter method when fluctuations in the interest rate data used for the estimation are volatile. © 2008 IMACS. Published by Elsevier B.V. All rights reserved.