Term Structure Modeling and Forecasting of Government Bond Yields: Does a Good In-Sample Fit Imply Reasonable Out-of-Sample Forecasts?

Accurate modelling and precise estimation of the term structure of interest rate are of crucial importance in many areas of finance and macroeconomics as it is the most important factor in the capital market and probably the economy. This study compares the in-sample fit and out-of-sample forecast accuracy of the Cox–Ingersoll–Ross (CIR) and Nelson–Siegel models. For the in-sample fit, there is a significant lack of information on the short-term CIR model. The CIR model should also be considered too poor to describe the term structure in a simulation-based context. It generates a downward slope average yield curve. Contrary to CIR model, Nelson–Siegel model is not only compatible to fit attractively the yield curve but also accurately forecast the future yield for various maturities. Furthermore, the non-linear version of the Nelson–Siegel model outperforms the linearised one. In a simulation-based context, the Nelson–Siegel model is capable to replicate most of the stylised facts of the Japanese market yield curve. Therefore, it turns out that the Nelson–Siegel model (non-linear version) could be a good candidate among various alternatives to study the evolution of the yield curve in Japanese market.