Accurate Short-Term Yield Curve Forecasting using Functional Gradient Descent

We propose a multivariate nonparametric technique for generating reliable short-term historical yield curve scenarios and confidence intervals. The approach is based on a Functional Gradient Descent (FGD) estimation of the conditional mean vector and covariance matrix of a multivariate interest rate series. It is computationally feasible in large dimensions and it can account for non-linearities in the dependence of interest rates at all available maturities. Based on FGD we apply filtered historical simulation to compute reliable out-of-sample yield curve scenarios and confidenceintervals. We back-test our methodology on daily USD bond data for forecasting horizons from 1 to 10 days. Based on several statistical p erformance measures we find significant evidence of a higher predictive power of our method when compared to scenarios generating techniques based on (i) factor analysis, (ii) a multivariate CCC-GARCH model, or (iii) an exp onential smoothing covariances estimator as in the RiskMetricsTM approach.