how efficient is the extended kalman filter at estimating ... · the cross section of yields are...

26
How Efficient is the Extended Kalman Filter at Estimating Shadow-Rate Models? Jens H. E. Christensen Federal Reserve Bank of San Francisco 101 Market Street, Mailstop 1130 San Francisco, CA 94105 Preliminary and incomplete draft. Comments are welcome. Abstract I perform a carefully orchestrated simulation exercise to study the efficiency of estimating an established Gaussian shadow-rate model with the extended Kalman filter. First, despite a near unit-root property imposed on the most persistent factor, finite-sample bias remains for the esti- mated persistence of other factors in the model. Second, parameters determined primarily from the cross section of yields are sensitive to sample length, data quality, and sampling frequency. Third, the accuracy of the filtered state variables improves with data quality and sampling fre- quency, but is insensitive to sample length. Also, filtering deteriorates when yields are severely compressed against the zero lower bound. Importantly, though, both the accuracy of the esti- mated parameters and the filtering performance are in general close to that reported elsewhere for affine Gaussian models estimated with the standard Kalman filter. Based on this evidence, I recommend using the extended Kalman filter for estimation of U.S. shadow-rate models, but question its use for estimation of Japanese shadow-rate models where interest rates have been severely depressed for prolonged periods. JEL Classification: C13, C58, G12, G17 Keywords: arbitrage-free Nelson-Siegel models, finite-sample bias The views in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. This version: August 24, 2015.

Upload: others

Post on 08-Aug-2020

3 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

How Efficient is the Extended Kalman Filter

at Estimating Shadow-Rate Models?

Jens H. E. Christensen

Federal Reserve Bank of San Francisco

101 Market Street, Mailstop 1130

San Francisco, CA 94105

Preliminary and incomplete draft. Comments are welcome.

Abstract

I perform a carefully orchestrated simulation exercise to study the efficiency of estimating an

established Gaussian shadow-rate model with the extended Kalman filter. First, despite a near

unit-root property imposed on the most persistent factor, finite-sample bias remains for the esti-

mated persistence of other factors in the model. Second, parameters determined primarily from

the cross section of yields are sensitive to sample length, data quality, and sampling frequency.

Third, the accuracy of the filtered state variables improves with data quality and sampling fre-

quency, but is insensitive to sample length. Also, filtering deteriorates when yields are severely

compressed against the zero lower bound. Importantly, though, both the accuracy of the esti-

mated parameters and the filtering performance are in general close to that reported elsewhere

for affine Gaussian models estimated with the standard Kalman filter. Based on this evidence,

I recommend using the extended Kalman filter for estimation of U.S. shadow-rate models, but

question its use for estimation of Japanese shadow-rate models where interest rates have been

severely depressed for prolonged periods.

JEL Classification: C13, C58, G12, G17

Keywords: arbitrage-free Nelson-Siegel models, finite-sample bias

The views in this paper are solely the responsibility of the author and should not be interpreted as reflecting theviews of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.

This version: August 24, 2015.

Page 2: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

1 Introduction

Modeling the term structure of interest rates is challenging and more so when rates are near their

zero lower bound as has been the case in the U.S. and elsewhere in recent years. To account for the

asymmetric behavior of bond yields near the zero lower bound, researchers and practitioners alike are

increasingly relying on so-called shadow-rate term structure models, where the instantaneous risk-free

rate is a truncated version of an underlying unobserved “shadow” process. Due to their nonlinear

yield function, estimation of shadow-rate models is non-standard and typically performed with the

extended Kalman filter, see Kim and Singleton (2012) and Christensen and Rudebusch (2015a) for

examples. However, little is known about the advantages and disadvantages of estimating shadow-

rate models in this way. Therefore, in this paper, I undertake a set of simulation experiments to

study the efficiency of the extended Kalman filter at estimatng Gaussian shadow-rate models.

In a recent paper, Christensen et al. (2015b, henceforth CLR) use simulations to analyze the

efficiency of the standard Kalman filter for estimation of arbitrage-free Nelson-Siegel (AFNS) models

with and without stochastic volatility. Here, I follow an approach similar to theirs and perform a

carefully orchestrated simulation study based on the established Gaussian shadow-rate AFNS model

described in Christensen and Rudebusch (2015b) and henceforth referred to as the B-CR model.1 I

then use the simulated data as input into model estimations based on the extended Kalman filter.

First, I find that, despite a near unit-root property imposed on the most persistent factor, finite-

sample bias remains for the estimated persistence of other factors in the model. This suggests that,

rather than correcting state variables individually, finite-sample bias correction should ideally be

performed on the joint dynamic system of the state variables as also argued by Bauer et al. (2012).

Second, the results show that parameters determined primarily from the cross section of yields

are sensitive to sample length, data quality, and sampling frequency.

Third, the accuracy of the filtered state variables improves with data quality and sampling fre-

quency, but is insensitive to sample length. Furthermore, a more detailed analysis of the infrequent

cases where the filtering deteriorates in quality reveals that this mainly happens when yields are

unusually low and severely compressed against the zero lower bound.

Importantly, though, both the accuracy of the estimated parameters and the filtering performance

are in general close to that reported by CLR for their simulation exercises based on the affine Gaussian

AFNS model where the standard Kalman filter is an efficient estimator equivalent to exact maximum

likelihood estimation. Based on this evidence, I conclude that, for estimation of Gaussian shadow-

rate models, the extended Kalman filter appears to be almost as efficient as the standard Kalman

filter is for affine Gaussian models. As a consequence, I recommend its use for estimation of U.S.

shadow-rate models. However, given that Japanese interest rates have been severely depressed for

1This model is also used in Christensen et al. (2015a).

1

Page 3: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

prolonged periods since 1995, the results would question its use for Japanese shadow-rate models.

The rest of the paper is structured as follows. Section 2 describes the B-CR model, while Section

3 details the extended Kalman filter estimation used throughout the paper. Section 4 lays out the

simulation exercise and Section 5 presents the results. Section 6 concludes the paper.

2 The B-CR Model

In the shadow-rate AFNS model introduced in Christensen and Rudebusch (2015a), the shadow risk-

free rate is unconstrained and defined as the sum of level and slope just like in the original AFNS

model class, while the short rate respects a nonnegativity constraint tied to the shadow rate:

st = Lt + St, rt = max0, st. (1)

The dynamics of the state variables used for pricing under the Q-measure remain as in the original

AFNS model class:

dLt

dSt

dCt

=

0 0 0

0 λ −λ0 0 λ

θQ1

θQ2

θQ3

Lt

St

Ct

dt+Σ

dWL,Qt

dW S,Qt

dWC,Qt

, λ > 0, (2)

where Σ is the constant covariance (or volatility) matrix.

By implication, the yield on the shadow discount bond maintains the popular Nelson and Siegel

(1987) factor loading structure

yt(τ) = Lt +

(1− e−λτ

λτ

)St +

(1− e−λτ

λτ− e−λτ

)Ct −

A(τ)

τ, (3)

where A(τ)/τ is the same maturity-dependent yield-adjustment term as in regular AFNS models,

see Christensen et al. (2011) for details.

The corresponding instantaneous shadow forward rate is given by

ft(τ) = − ∂

∂TlnPt(τ) = Lt + e−λτSt + λτe−λτCt +Af (τ), (4)

2

Page 4: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

where the yield-adjustment term in the instantaneous forward rate function is given by

Af (τ) = −∂A(τ)∂τ

= −1

2σ211τ

2 − 1

2(σ221 + σ222)

(1− e−λτ

λ

)2

−1

2(σ231 + σ232 + σ233)

[ 1

λ2− 2

λ2e−λτ − 2

λτe−λτ +

1

λ2e−2λτ +

2

λτe−2λτ + τ2e−2λτ

]

−σ11σ21τ1− e−λτ

λ− σ11σ31

[1λτ − 1

λτe−λτ − τ2e−λτ

]

−(σ21σ31 + σ22σ32)[ 1

λ2− 2

λ2e−λτ − 1

λτe−λτ +

1

λ2e−2λτ +

1

λτe−2λτ

].

Krippner (2013) provides a formula for the zero lower bound instantaneous forward rate, ft(τ),

that applies to any Gaussian model

ft(τ) = ft(τ)Φ

(ft(τ)ω(τ)

)+ ω(τ)

1√2π

exp(− 1

2

[ft(τ)ω(τ)

]2),

where Φ(·) is the cumulative probability function for the standard normal distribution, ft(τ) is the

shadow forward rate, and ω(τ) is related to the conditional variance, v(τ, τ + δ), appearing in the

shadow bond option price formula as follows

ω(τ)2 =1

2limδ→0

∂2v(τ, τ + δ)

∂δ2.

Within the shadow-rate AFNS model, ω(τ) takes the following form

ω(τ)2 = σ2

11τ + (σ2

21+ σ2

22)1− e−2λτ

2λ+ (σ2

31+ σ2

32+ σ2

33)[1− e−2λτ

4λ− 1

2τe−2λτ − 1

2λτ2e−2λτ

]

+2σ11σ211− e−λτ

λ+ 2σ11σ31

[− τe−λτ +

1− e−λτ

λ

]+ (σ21σ31 + σ22σ32)

[− τe−2λτ +

1− e−2λτ

].

Therefore, the zero-coupon bond yields that observe the zero lower bound, denoted yt(τ), are easily

calculated as

yt(τ) =

1

τ

∫ t+τ

t

[ft(s)Φ

(ft(s)ω(s)

)+ ω(s)

1√2π

exp(− 1

2

[ft(s)ω(s)

]2)]ds. (5)

Similar to the affine AFNS model, the shadow-rate AFNS model is completed by specifying the

price of risk using the essentially affine risk premium specification introduced by Duffee (2002), so

the real-world dynamics of the state variables can be expressed as

3

Page 5: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

dLt

dSt

dCt

=

κP11

κP12

κP13

κP21

κP22

κP23

κP31

κP32

κP33

θP1

θP2

θP3

Lt

St

Ct

dt+

σ11 0 0

σ21 σ22 0

σ31 σ32 σ33

dWL,Pt

dWS,Pt

dWC,Pt

. (6)

In this unrestricted case, both KP and θP are allowed to vary freely relative to their counterparts

under the Q-measure. However, I focus on the case with the same KP and θP restrictions as in

Christensen and Rudebusch (2012, 2015b)

dLt

dSt

dCt

=

10−7 0 0

κP21 κP22 κP23

0 0 κP33

0

θP2

θP3

Lt

St

Ct

dt+Σ

dWL,Pt

dW S,Pt

dWC,Pt

. (7)

I label this shadow-rate model the “B-CR model.”2

3 The Extended Kalman Filter Estimation

Thanks to the nonlinear measurement equation (5), I estimate the B-CR model using the extended

Kalman filter. In the following, I first describe the standard Kalman filter that is efficient for affine

Gaussian models before I proceed to a description of the extended Kalman filter that I use in the

remainder of the paper to estimate the B-CR model.

For affine Gaussian models, in general, the conditional mean vector and the conditional covariance

matrix are

EP [XT |Ft] = (I − exp(−KP∆t))θP + exp(−KP∆t)Xt,

V P [XT |Ft] =

∫ ∆t

0e−KP sΣΣ′e−(KP )′sds,

where ∆t = T − t. I compute conditional moments of discrete observations and obtain the state

transition equation

Xt = (I − exp(−KP∆t))θP + exp(−KP∆t)Xt−1 + ξt,

where ∆t is the time between observations. In the standard Kalman filter, the measurement equation

would be affine, in which case

yt = A+BXt + εt.

2Following Kim and Singleton (2012), the prefix “B-” refers to a shadow-rate model in the spirit of Black (1995).

4

Page 6: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

The assumed error structure is

(ξt

εt

)∼ N

[(0

0

),

(Q 0

0 H

)],

where the matrix H is assumed diagonal, while the matrix Q has the following structure:

Q =

∫ ∆t

0e−KP sΣΣ′e−(KP )′sds.

In addition, the transition and measurement errors are assumed orthogonal to the initial state.

Now, I consider Kalman filtering, which is used to evaluate the likelihood function.

Normally, the state variables are assumed to be stationary, in which case the filter is initialized

at the unconditional mean and variance of the state variables under the P -measure: X0 = θP and

Σ0 =∫∞0 e−KP sΣΣ′e−(KP )′sds, which are calculated using the analytical solutions provided in Fisher

and Gilles (1996). In case of the B-CR model, the state variables have a near unit root and the

Kalman filter algorithm is initialized in a different way as explained below.

Denote the information available at time t by Yt = (y1, y2, . . . , yt), and denote model parameters

by ψ. Consider period t−1 and suppose that the state update Xt−1 and its mean square error matrix

Σt−1 have been obtained. The prediction step is

Xt|t−1 = EP [Xt|Yt−1] = ΦX,0t (ψ) + ΦX,1

t (ψ)Xt−1,

Σt|t−1 = ΦX,1t (ψ)Σt−1Φ

X,1t (ψ)′ +Qt(ψ),

where ΦX,0t = (I−exp(−KP∆t))θP , ΦX,1

t = exp(−KP∆t), and Qt =∫∆t

0 e−KP sΣΣ′e−(KP )′sds, while

∆t is the time between observations.

In the update step at time t, Xt|t−1 is improved by using the additional information contained in

Yt. We have that

Xt = E[Xt|Yt] = Xt|t−1 +Σt|t−1B(ψ)′F−1t vt,

Σt = Σt|t−1 −Σt|t−1B(ψ)′F−1t B(ψ)Σt|t−1,

where

vt = yt −E[yt|Yt−1] = yt −A(ψ)−B(ψ)Xt|t−1,

Ft = cov(vt) = B(ψ)Σt|t−1B(ψ)′ +H(ψ),

H(ψ) = diag(σ2ε (τ1), . . . , σ2ε(τN )).

5

Page 7: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

At this point, the Kalman filter has delivered all ingredients needed to evaluate the Gaussian log

likelihood, the prediction-error decomposition of which is

log l(y1, . . . , yT ;ψ) =

T∑

t=1

(− N

2log(2π) − 1

2log |Ft| −

1

2v′tF

−1t vt

),

where N is the number of observed yields. The likelihood is numerically maximized with respect to

ψ using the Nelder-Mead simplex algorithm. Upon convergence, standard errors are obtained from

the estimated covariance matrix,

Ω(ψ) =1

T

[ 1T

T∑

t=1

∂ log lt(ψ)

∂ψ

∂ log lt(ψ)

∂ψ

′]−1,

where ψ denotes the estimated model parameters.

This completes the description of the standard Kalman filter. However, in shadow-rate models,

zero-coupon bond yields are not affine functions of the state variables. Instead, the measurement

equation takes the general form

yt = z(Xt;ψ) + εt.

In the extended Kalman filter used in this paper, this equation is linearized through a first-order

Taylor expansion around the best guess of Xt in the prediction step of the Kalman filter algorithm.

Thus, in the notation introduced above, this best guess is denoted Xt|t−1 and the approximation is

given by

z(Xt;ψ) ≈ z(Xt|t−1;ψ) +∂z(Xt;ψ)

∂Xt

∣∣∣Xt=Xt|t−1

(Xt −Xt|t−1).

Now, by defining3

At(ψ) ≡ z(Xt|t−1;ψ)−∂z(Xt;ψ)

∂Xt

∣∣∣Xt=Xt|t−1

Xt|t−1 and Bt(ψ) ≡∂z(Xt;ψ)

∂Xt

∣∣∣Xt=Xt|t−1

,

the measurement equation can be given in an affine form as

yt = At(ψ) +Bt(ψ)Xt + εt,

and the steps in the algorithm proceeds as previously described for the standard Kalman filter.

However, due to the approximation above, the optimization of the likelihood function is referred to

as quasi maximum likelihood.

Normally, the unconditional distribution of the state variables is used to start the Kalman filter.

However, with a unit-root property imposed on the Nelson-Siegel level factor, the joint dynamics

3The derivatives involved are calculated numerically.

6

Page 8: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

of the state variables are no longer stationary and the unconditional distribution does not exist.

Instead, I follow Duffee (1999) and derive a distribution for the starting point of the Kalman filter

based on the yields observed at the first data point in the sample.

As already noted, the yield function in shadow-rate models is nonlinear

yt = z(Xt;ψ) + εt,

which complicates the adaptation of Duffee’s (1999) approach. However, for U.S. Treasury data that

date back before the financial crisis it is the case that yields are far away from the zero lower bound.

Under those circumstances the shadow-rate AFNS model—like any shadow-rate model—collapses to

its equivalent regular model since the option to hold currency is far out of the money. Thus, the

yield function for the initial yield observation will be well approximated by4

yt = A(ψ) +B(ψ)Xt + εt, εt ∼ N(0,H),

where A(ψ) and B(ψ) are calculated from the corresponding regular AFNS model.

For the first set of observations, I rewrite this equation as

y1 = A(ψ) +B(ψ)X0 + ε0 ⇐⇒ B(ψ)X0 = y1 −A(ψ) − ε0.

Now, multiply from the left on both sides by B(ψ)′ to obtain

B(ψ)′B(ψ)X0 = B(ψ)′(y1 −A(ψ)) −B(ψ)′ε0.

Then, X0 can be isolated by using the inverse of B(ψ)′B(ψ)

X0 = (B(ψ)′B(ψ))−1B(ψ)′(y1 −A(ψ)) − (B(ψ)′B(ψ))−1B(ψ)′ε0.

Here, ε0 is normally distributed with a mean of zero and a covariance matrix equal to H. By

implication, X0 follows a normal distribution with the following properties

X0 ∼ N [(B(ψ)′B(ψ))−1B(ψ)′(y1 −A(ψ)), (B(ψ)′B(ψ))−1B(ψ)′HB(ψ)(B(ψ)′B(ψ))−1].

This is the normal distribution used to start the Kalman filter when a unit-root property is assumed.5

4Obviously, for the simulated yield samples studied later on, it will not always be the case that the initial yields arefar from the zero lower bound, but even then the committed error is likely to be relatively small and only applies tothe first observation date.

5Note that this approach generalizes to estimation of non-Gaussian affine models where nonstationarity is required.See Duffee (1999) for an example.

7

Page 9: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

1985 1990 1995 2000 2005 2010 2015

02

46

810

12

Rat

e in

per

cent

Ten−year yield Five−year yield Two−year yield Three−month yield

Figure 1: Treasury Yields.

The figure shows three-month, two-year, five-year, and ten-year weekly U.S. Treasury zero-coupon bond yields

from January 4, 1985, to October 31, 2014.

KP KP·,1 KP

·,2 KP·,3 θP Σ

KP1,· 10−7 0 0 0 σ11 0.0069

(0.0001)KP

2,· 0.1953 0.3138 -0.4271 0.0014 σ22 0.0112

(0.1474) (0.1337) (0.0904) (0.0364) (0.0002)KP

3,· 0 0 0.4915 -0.0252 σ33 0.0257

(0.1200) (0.0087) (0.0004)

Table 1: Parameter Estimates for the B-CR Model.

The estimated parameters of the KP matrix, θP vector, and diagonal Σ matrix are shown for the B-CR model.

The estimated value of λ is 0.4700 (0.0026). The numbers in parentheses are the estimated parameter standard

deviations. The quasi maximum log likelihood value is 71,408.90.

4 The Simulation Exercise

To begin the simulation exercise, I first estimate the B-CR model on a weekly sample of U.S. Treasury

yields containing eight yields with maturities from three months to ten years covering the period

January 4, 1985, until October 31, 2014. Four of the eight yield series are shown in Figure 1.

The estimated model parameters are shown in Table 1 and identical to the estimates reported in

8

Page 10: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

Christensen and Rudebusch (2015b).6 I use these parameters as the true parameters in the model

simulations.

Second, thanks to the unit-root property imposed on the level factor in the B-CR model, the

unconditional distribution of the state variables is not well defined. As a consequence, starting

values for each simulation cannot be obtained in the usual way. Instead, I generate the initial

conditions in each simulation by randomly drawing a state variable vector from the set of filtered

state variables implied by the B-CR model estimation using U.S. Treasury yields as described above.

This set contains a total of 1,557 such vectors. This is repeated N = 1,000 times.

Third, to simulate sample paths for the three state variables, I approximate the continuous-time

dynamics in equation (7) using the Euler approximation.7 To provide a stylized example,

dXit = κPii (θ

Pi −Xi

t)dt+ κPij(θPj −Xj

t )dt+ σiidWP,it

is approximated using

Xit = Xi

t−1 + κPii (θPi −Xi

t−1)∆t+ κPij(θPj −Xj

t−1)∆t+ σii√∆tzit, zit ∼ N(0, 1),

where I fix ∆t at a uniform value of 0.0001.

In one set of exercises, I simulate 1,000 samples with a length of ten years observed at weekly

and monthly frequency. It is important to emphasize that it is the same 1,000 sample paths that

are being simulated according to the algorithm above independent of the sampling frequency. This

is done to make the results as comparable as possible estimation by estimation. In the other set

of exercises, I simulate 1,000 samples with a length of thirty years observed at weekly and monthly

frequency. Again, it is the same 1,000 sample paths that are being simulated according to the

algorithm independent of the sampling frequency. Furthermore, it is the same 1,000 starting values

for the three state variables that are used in all exercises, again in an attempt to make the results as

comparable as possible throughout.

In the fourth step, these simulated factor paths are converted into simulated zero-coupon yields

with eight maturities, 0.25, 0.5, 1, 2, 3, 5, 7, and 10 years, using the yield function in equation (5).

Finally, Gaussian i.i.d. measurement errors are added to the bond yields. In one set of exercises,

the measurement error standard deviation is fixed uniformly at σε = 1 basis point. In the other set

of exercises, it is fixed uniformly at σε = 10 basis points. It should be noted that the simulated

measurement errors are the same independent of the value of σε. Also, it is important to note

that this may cause the simulated yields to be negative provided the measurement error shocks are

sufficiently negative. As an alternative, the simulated yields including the measurement errors could

6See Christensen and Rudebusch (2015b) for details of the data.7Thompson (2008) is an example.

9

Page 11: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

be truncated at zero, but the effect of doing this should be small and is left for future research.

In the final step, all these simulated yield samples are used as input in estimations of the B-CR

model based on the extended Kalman filter where each estimation is started at the true parameters

shown in Table 1. Thus, we are estimating the true model, which should provide the cleanest read

possible on the efficiency of the extended Kalman filter for the estimation of Gaussian shadow-rate

models such as the B-CR model.

5 Results

In this section, I first provide a detailed description of the results from the simulated ten-year monthly

samples. Second, I summarize the results from the simulated ten-year weekly samples before I end

the section with a brief description of the results from the simulated thirty-year samples.

5.1 Analysis of Ten-Year Monthly Samples

Table 2 reports the summary statistics for the estimated parameters from the simulated ten-year

samples at monthly frequency with low and high noise in the data. First, I note that there is notable

upward bias in the absolute values of the estimated mean-reversion parameters. This suggests that

imposing high persistence for the level factor in AFNS models may address the finite-sample bias

problem for that factor, but it does not necessarily mitigate it for other factors in the model. This is

also clear from Figure 2, which shows the distribution of the estimated mean-reversion parameters

across all 1,000 estimations for the data with high noise. It is only the estimates of κP23 that tend to

fall in a fairly narrow range. Furthermore, since the parameters in KP are primarily determined from

the time-series dimension, it is worth emphasizing that these results are not sensitive to the data

quality, and they suggest that a full correction of finite-sample bias should target the joint dynamics

of all state variables as also argued by Bauer et al. (2012).

Second, it is noted that the finite-sample bias in the estimated mean-reversion parameters has a

negative effect on the accuracy of the estimated mean parameters; in particular the estimated mean

of the slope factor, θP2 , is poorly identified. This is partly a result of the fact that the level factor

with its near unit-root property affects the dynamics of the slope factor through κP21. However, even

for the curvature factor, which is not affected by any other factors, estimates of θP3 fall in a wide

range relative to the ranges of mean estimates reported by CLR from simulated ten-year monthly

samples of their Gaussian AFNS model.

Turning to the three volatility parameters in the Σ matrix, I note that they are well determined

with almost identical means and medians, both close to the true values, and the standard deviations

of their estimates are also small. Importantly, though, their accuracy is sensitive to the quality of the

data as a low value of σε decreases the dispersion of their estimated values. This result applies to all

10

Page 12: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

Ten-year samples, σε = 1 bpParameter

True Mean Std. dev. 5% 1st quartile Median 3rd quartile 95%

κP21

0.1953 0.5599 1.1269 -1.1297 -0.0860 0.4431 1.1643 2.4673κP22

0.3138 0.8315 0.5910 0.1197 0.4312 0.6984 1.1114 1.9742κP23

-0.4271 -0.5163 0.3567 -1.0879 -0.7187 -0.5116 -0.3017 0.0514κP33

0.4915 0.9424 0.5836 0.1044 0.5481 0.8471 1.2443 2.0223

σ11 0.0069 0.0068 0.0003 0.0062 0.0066 0.0068 0.0070 0.0073σ22 0.0112 0.0112 0.0009 0.0098 0.0106 0.0112 0.0117 0.0125σ33 0.0257 0.0261 0.0021 0.0231 0.0247 0.0260 0.0273 0.0293

θP2

0.0014 -0.1901 4.9064 -0.2041 -0.0494 0.0054 0.0808 0.3603θP3

-0.0252 -0.0142 0.1676 -0.0594 -0.0348 -0.0239 -0.0110 0.0107

λ 0.4700 0.4716 0.0055 0.4644 0.4683 0.4708 0.4743 0.4816

σε 0.0010 0.0001 0.0001 0.0000 0.0001 0.0001 0.0001 0.0001

Ten-year samples, σε = 10 bpsParameter

True Mean Std. dev. 5% 1st quartile Median 3rd quartile 95%

κP21

0.1953 0.4208 1.1653 -1.1977 -0.1504 0.3836 0.9444 1.9515κP22

0.3138 0.8799 1.4997 0.1869 0.4438 0.6961 1.0558 1.9599κP23

-0.4271 -0.5105 0.4641 -1.0408 -0.6858 -0.5060 -0.3315 -0.0486κP33

0.4915 0.9709 0.6104 0.2445 0.5447 0.8447 1.2484 2.1176

σ11 0.0069 0.0067 0.0008 0.0054 0.0062 0.0067 0.0073 0.0081σ22 0.0112 0.0108 0.0014 0.0086 0.0102 0.0110 0.0116 0.0127σ33 0.0257 0.0260 0.0033 0.0209 0.0241 0.0262 0.0281 0.031

θP2

0.0014 -0.0035 0.4111 -0.1692 -0.0560 -0.0001 0.0603 0.2479θP3

-0.0252 -0.0229 0.0417 -0.0559 -0.0373 -0.0248 -0.0133 0.0064

λ 0.4700 0.4685 0.0252 0.4303 0.4549 0.4685 0.4825 0.5078

σε 0.0010 0.0010 0.0001 0.0010 0.0010 0.0010 0.0010 0.0010

Table 2: Summary Statistics of Estimated Parameters from Simulated Ten-Year Monthly

Samples of the B-CR Model.

The table reports the summary statistics of the estimation results from N = 1,000 simulated data sets of the

B-CR model, each with a length of ten years at monthly frequency and a uniform measurement error standard

deviation of σε = 1 basis point and σε = 10 basis points, respectively.

three factors, and it suggests that the values of the volatility parameters are determined to a large

extent from their impact on the cross-sectional fit of yields rather than from the time series properties

of the state variables, which are the same in the simulated data by construction and independent of

the value of σε.

Focusing on the estimates of λ, Table 2 shows that this parameter is well determined in the

estimation without any measurable bias and with a small standard deviation. Since λ only affects

the risk-neutral Q-dynamics, it is exclusively determined from the cross section of yields and therefore

sensitive to the quality of the data.

As for filtering, Table 3 reports the summary statistics for the mean absolute error of the filtering

of the three state variables in the ten-year monthly samples. The results show that the filtering of

11

Page 13: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

0 200 400 600 800 1000

−4

−2

02

46

Estimation No.

Par

amet

er e

stm

ate

(a) κP

21.

0 200 400 600 800 1000

01

23

4

Estimation No.

Par

amet

er e

stm

ate

(b) κP

22.

0 200 400 600 800 1000

−3

−2

−1

01

2

Estimation No.

Par

amet

er e

stm

ate

(c) κP

23.

0 200 400 600 800 1000

01

23

45

Estimation No.

Par

amet

er e

stm

ate

(d) κP

33.

Figure 2: Estimated Mean-Reversion Parameters from Simulated Ten-Year Monthly

Samples of the B-CR Model.

Illustration of the estimated mean-reversion parameters in the KP matrix from N = 1,000 simulated data

sets of the B-CR model, each with a length of ten years sampled monthly and a uniform measurement error

standard deviation of σε = 10 basis points. The true value of each parameter is indicated with a horizontal

solid grey line.

the state variables is in general only marginally less accurate than the results reported by CLR from

simulations and subsequent estimations of a regular AFNS model based on the standard Kalman

filter. However, it is also clear that there are samples in the tail of the distribution that produce

notably higher mean absolute filtered errors, a phenomenon not observed for regular AFNS models.

12

Page 14: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

State Mean absolute fitted error, ten-year samples, σε = 1 bpvariable Mean Std. dev. 5 percentile 1st quartile Median 3rd quartile 95 percentileLt 2.31 0.75 1.68 1.81 2.01 2.61 3.75St 4.61 5.83 1.45 1.59 1.88 5.02 16.23Ct 8.92 6.26 4.56 5.01 5.76 10.85 21.70

State Mean absolute fitted error, ten-year samples, σε = 10 bpsvariable Mean Std. dev. 5 percentile 1st quartile Median 3rd quartile 95 percentileLt 13.70 2.07 11.35 12.42 13.24 14.37 17.46St 16.34 9.24 10.73 11.83 12.83 16.47 36.14Ct 42.70 12.97 32.40 35.47 38.38 44.25 68.90

Table 3: Summary Statistics of Mean Absolute Fitted Errors of the Filtered State Vari-

ables from Simulated Ten-Year Monthly Samples of the B-CR Model.

The table reports the summary statistics of the mean absolute fitted error of the three state variables from

N = 1,000 simulated data sets of the B-CR model, each with a length of ten years sampled monthly and a

uniform measurement error standard deviation of σε = 1 basis point and σε = 10 basis points, respectively.

All numbers are measured in basis points.

0 2 4 6 8 10

0.04

0.05

0.06

0.07

0.08

0.09

0.10

Fact

or v

alue

Simulated level factor Estimated level factor

(a) Lt.

0 2 4 6 8 10

−0.

04−

0.02

0.00

0.02

0.04

0.06

0.08

Fact

or v

alue

Simulated slope factor Estimated slope factor

(b) St.

0 2 4 6 8 10

−0.

050.

000.

050.

10

Fact

or v

alue

Simulated curvature factor Estimated curvature factor

(c) Ct.

Figure 3: Estimated Factor Paths with Median Error from Simulated Ten-Year Monthly

Samples of the B-CR Model.

Illustration of the estimated factor paths of the three state variables from the sample that produces the median

mean absolute filtering error for the curvature factor across N = 1,000 simulated data sets of the B-CR model,

each with a length of ten years at monthly frequency and a uniform measurement error standard deviation of

σε = 10 basis points. Also shown are the true simulated factor paths from that sample.

In the following, I analyze the cause of this difference in filtering accuracy.

5.1.1 When Does Filtering Fail in Shadow-Rate Models?

As indicated by the summary statistics in Table 3, the filtering in shadow-rate models based on the

extended Kalman filter is accurate most of the time even when the noise in the data is high. To

provide an example of this, Figure 3 shows the true and filtered state variables from the sample

13

Page 15: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

0 2 4 6 8 10

0.0

0.5

1.0

1.5

2.0

Rat

e in

per

cent

Ten−year yield Five−year yield Two−year yield Three−month yield

(a) Simulated yields.

1995 2000 2005 2010 2015

01

23

45

67

89

Rat

e in

per

cent

US ten−year yield US two−year yield US one−year yield Japanese ten−year yield Japanese two−year yield Japanese one−year yield

(b) U.S. and Japanese yields.

Figure 4: Time Series of Simulated and Observed Yields.

Panel (a) shows the simulated monthly zero-coupon bond yields from the sample that produces the maximum

mean absolute filtering error for the curvature factor across N = 1,000 simulated data sets of the B-CR model,

each with a length of ten years at monthly frequency and a uniform measurement error standard deviation of

σε = 1 basis point. The yields shown have maturities: Three-month, two-year, five-year, and ten-year. Panel

(b) shows U.S. Treasury and Japanese government bond yields at daily frequency from January 1995 to July

2015. The yields shown have maturities: one-year, two-year, and ten-year.

that generates the median mean absolute filtering error for the curvature factor (38.4 basis points)

across the 1,000 simulated data sets of the B-CR model, each with a length of ten years at monthly

frequency and a uniform measurement error standard deviation of σε = 10 basis points. It is evident

that the filtering is successful in this case.

To better understand the failure of the extended Kalman filter for the samples in the tail with

much higher mean absolute filtered errors, I focus on the high-quality sample that generates the least

accurate filtering as measured by the mean absolute filtered error for the curvature factor. Despite

ideal conditions, the mean absolute filtered errors for the three factors are 7.5 basis points, 50.1 basis

points, and 54.0 basis points, respectively, for this particular sample. From Table 3 it follows that

these are large filtered errors even relative to the low-quality ten-year monthly samples. Four of the

eight yield series from this sample are shown in Figure 4(a). Clearly, this sample is characterized by

a very prolonged period of extremely low and compressed interest rates, even at longer maturities.8

In terms of practical relevance, this simulated sample of yields do share similarities with the sample

of Japanese government bond yields analyzed in Kim and Singleton (2012), extended by Christensen

8Thanks to the added Gaussian measurement errors, the simulated yields can become negative when they are nearthe zero lower bound.

14

Page 16: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

0 2 4 6 8 10

−0.

02−

0.01

0.00

0.01

0.02

0.03

0.04

Fact

or v

alue

Simulated level factor Estimated level factor

(a) Lt.

0 2 4 6 8 10

−0.

10−

0.08

−0.

06−

0.04

−0.

020.

000.

02

Fact

or v

alue

Simulated slope factor Estimated slope factor

(b) St.

0 2 4 6 8 10

−0.

10−

0.06

−0.

020.

020.

04

Fact

or v

alue

Simulated curvature factor Estimated curvature factor

(c) Ct.

Figure 5: Estimated Factor Paths with Maximum Error from Simulated Ten-Year

Monthly Samples of the B-CR Model.

Illustration of the estimated factor paths of the three state variables from the sample that produces the maxi-

mum mean absolute filtering error for the curvature factor across N = 1,000 simulated data sets of the B-CR

model, each with a length of ten years at monthly frequency and a uniform measurement error standard

deviation of σε = 1 basis point. Also shown are the true simulated factor paths from that sample.

and Rudebusch (2015a), and shown in Figure 4(b). Since both of these studies estimate Gaussian

shadow-rate models based on the extended Kalman filter, the accuracy of their estimated state

variables could be questioned based on these findings.9 On the other hand, the U.S. Treasury yields

also shown in Figure 4(b) so far have not reached such depressingly low levels, which suggests that

those data are much less likely to pose a problem for the extended Kalman filter.

Figure 5 shows the individual true and filtered state variables for this sample. It is noteworthy

that the filtering of the level factor tends to stay on track even under such extreme circumstances.

Thus, this factor is reliably estimated as long as long-term yields are not compressed against the

zero lower bound. On the other hand, the filtering of the slope and curvature factors can be thrown

off for extended periods when short- and medium-term yields are compressed against the zero lower

bound.

Figure 6 shows the true and estimated shadow-rate paths from this particular sample. When

yields are particularly low during the years 2 to 6, the estimated value of the shadow rate can be off

by as much as 200 basis points in either direction. This lack of econometric identification is caused by

the fact that the shadow rate is deep in negative territory during this period. More importantly, these

findings reinforce the concerns raised by Christensen and Rudebusch (2015a) about the accuracy of

estimated shadow rates and their use as a measure of the stance of monetary policy when bond yields

are constrained by the zero lower bound. In particular, it is ironic that it is exactly at the times when

9To reach a more final conclusion regarding this question would require repeating the simulation exercise usingparameters estimated from their Japanese yield sample. This is left for future research.

15

Page 17: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

0 2 4 6 8 10

−10

−8

−6

−4

−2

02

Rat

e in

per

cent

Simulated shadow rate Estimated shadow rate

Figure 6: Estimated Shadow Rate.

Illustration of the estimated shadow-rate path from the sample that produces the maximum mean absolute

filtering error for the curvature factor across N = 1,000 simulated data sets of the B-CR model, each with a

length of ten years at monthly frequency and a uniform measurement error standard deviation of σε = 1 basis

point. Also shown are the true simulated shadow-rate path from that sample.

such an analysis would be most useful that it is most unreliable, namely when yields are severely

constrained by the zero lower bound.

Furthermore, these results leave an interesting empirical question whether other nonlinear filter-

ing and estimation methods would be able to overcome the problems encountered with the extended

Kalman filter when the nonlinearities in the data are particularly severe. For Japanese data, Chris-

tensen and Rudebusch (2015a) report almost identical results using the unscented Kalman filter

relative to the standard extended Kalman filter, which in itself suggests that the unscented Kalman

filter likely would not suffice. However, the robustness of their result is unknown and is a topic left

for future research.

5.2 Analysis of Ten-Year Weekly Samples

Given that I, like Christensen and Rudebusch (2015b), estimate the B-CR model using weekly U.S.

Treasury data, the empirically relevant case is really with data at weekly frequency, which is the

focus of this section.

Table 4 reports the summary statistics of the estimated parameters based on the 1,000 simulated

16

Page 18: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

Ten-year samples, σε = 1 bpParameter

True Mean Std. dev. 5% 1st quartile Median 3rd quartile 95%

κP21

0.1953 0.4007 0.9299 -1.0517 -0.0735 0.3606 0.9142 1.8652κP22

0.3138 0.7932 0.5185 0.1927 0.4480 0.6833 1.0223 1.7764κP23

-0.4271 -0.5098 0.2833 -0.9753 -0.6784 -0.5089 -0.3231 -0.0753κP33

0.4915 0.9347 0.5377 0.2590 0.5538 0.8382 1.2057 2.0475

σ11 0.0069 0.0068 0.0002 0.0066 0.0067 0.0069 0.0070 0.0071σ22 0.0112 0.0112 0.0004 0.0106 0.0110 0.0112 0.0114 0.0118σ33 0.0257 0.0259 0.0009 0.0246 0.0253 0.0258 0.0264 0.0272

θP2

0.0014 0.0247 0.2808 -0.1630 -0.0536 -0.0014 0.0565 0.2479θP3

-0.0252 -0.0253 0.0328 -0.0552 -0.0371 -0.0253 -0.0135 0.0023

λ 0.4700 0.4704 0.0021 0.4674 0.4691 0.4703 0.4715 0.4739

σε 0.0001 0.0001 0.0001 0.0000 0.0001 0.0001 0.0001 0.0001

Ten-year samples, σε = 10 bpsParameter

True Mean Std. dev. 5% 1st quartile Median 3rd quartile 95%

κP21

0.1953 0.4373 2.4085 -1.0587 -0.1585 0.3213 0.8306 1.8221κP22

0.3138 0.9321 3.3836 0.2038 0.4436 0.6623 1.0372 1.8160κP23

-0.4271 -0.5116 0.3328 -0.9899 -0.6820 -0.5073 -0.3360 -0.0805κP33

0.4915 0.9560 0.5687 0.2718 0.5612 0.8306 1.2316 2.0675

σ11 0.0069 0.0068 0.0005 0.0060 0.0065 0.0068 0.0072 0.0076σ22 0.0112 0.0110 0.0010 0.0096 0.0106 0.0111 0.0116 0.0122σ33 0.0257 0.0258 0.0019 0.0229 0.0246 0.0259 0.0271 0.0286

θP2

0.0014 -0.0009 0.1968 -0.1602 -0.0553 -0.0024 0.0502 0.1936θP3

-0.0252 -0.0244 0.0449 -0.0554 -0.0373 -0.0253 -0.0131 0.0037

λ 0.4700 0.4704 0.0122 0.4508 0.4633 0.4702 0.4774 0.4898

σε 0.0010 0.0010 0.0001 0.0010 0.0010 0.0010 0.0010 0.0010

Table 4: Summary Statistics of Estimated Parameters from Simulated Ten-Year Weekly

Samples of the B-CR Model.

The table reports the summary statistics of the estimation results from N = 1,000 simulated data sets of the

B-CR model, each with a length of ten years at weekly frequency and a uniform measurement error standard

deviation of σε = 1 basis point and σε = 10 basis points, respectively.

ten-year weekly samples. First, the upward finite-sample bias for κP21 is reduced fairly notably when

the sampling frequency is increased. For the other mean-reversion parameters the improvement is

more modest. However, the standard deviations of their estimates are lowered by a meaningful

amount. Second, the sizable variation in the mean parameters drops significantly when the sampling

frequency is increased, but remains unsatisfactorily large, in particular for estimates of θP2 . Third,

for the parameters determined primarily from the cross section of yields (Σ and λ), the already high

accuracy is further improved. As a result, the standard deviations of their parameter estimates are

very low when the sampling frequency is weekly. These findings are consistent with CLR, who report

similar results when they increase sampling frequency.

Turning to the filtering of the state variables, Table 9 reports the summary statistics for the mean

17

Page 19: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

State Mean absolute fitted error, ten-year samples, σε = 1 bpvariable Mean Std. dev. 5 percentile 1st quartile Median 3rd quartile 95 percentileLt 1.99 0.44 1.67 1.75 1.83 2.04 2.83St 2.87 3.33 1.47 1.54 1.64 2.57 9.13Ct 6.68 3.72 4.60 4.78 5.10 6.91 14.43

State Mean absolute fitted error, ten-year samples, σε = 10 bpsvariable Mean Std. dev. 5 percentile 1st quartile Median 3rd quartile 95 percentileLt 10.25 1.33 8.96 9.45 9.92 10.64 12.73St 12.67 7.06 8.97 9.45 10.03 12.12 26.98Ct 32.72 9.24 26.12 27.81 29.33 33.59 52.54

Table 5: Summary Statistics of Mean Absolute Fitted Errors of the Filtered State Vari-

ables from Simulated Ten-Year Weekly Samples of the B-CR Model.

The table reports the summary statistics of the mean absolute fitted error of the three state variables from N =

1,000 simulated data sets of the preferred AFNS0 model, each with a length of ten years sampled weekly and

a uniform measurement error standard deviation of σε = 1 basis point and σε = 10 basis points, respectively.

All numbers are measured in basis points.

absolute errors of the filtered state variables from the individual samples. By comparing the results

to those from the monthly samples shown in Table 3, it is clear that the filtering of the state variables

improves when the sampling is increased from monthly to weekly frequency, and the improvement is

larger the more noisy the data is.

As for the samples that cause the extended Kalman filter problems, they are practically the same

independent of the sampling frequency. To illustrate, the sample that generated the maximum mean

absolute filtering error for the curvature factor in the ten-year monthly samples now generates the

second largest mean absolute filtering error for the curvature factor.10 The estimated shadow rate

from this weekly sample is shown in Figure 7 and exhibits the same material deviation for the years

from 2 to 6 as noted in Figure 6 at monthly sampling frequency. Thus, to move to higher frequency

data is not a remedy for the filtering problem in the extended Kalman filter under extreme conditions,

at most it can mitigate it modestly.

5.3 Analysis of Thirty-Year Monthly Samples

In this section, I analyze the results obtained for the thirty-year monthly samples simulated from the

B-CR model.

For a start, Table 6 contains the summary statistics for the 1,000 estimated parameter sets

we obtain from these thirty-year monthly samples. For the mean-reversion parameters, there is a

significant reduction in their finite-sample bias that is also noted in Figure 8, which shows their

10The sample that generates the largest mean absolute filtered error for the curvature factor in the weekly datagenerates the fifth largest mean absolute filtered error for the curvature factor in the monthly data.

18

Page 20: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

0 2 4 6 8 10

−10

−8

−6

−4

−2

02

Rat

e in

per

cent

Simulated shadow rate Estimated shadow rate

Figure 7: Estimated Shadow Rate.

Illustration of the estimated shadow-rate path from the sample that produces the second highest mean absolute

filtering error for the curvature factor across N = 1,000 simulated data sets of the B-CR model, each with a

length of ten years at weekly frequency and a uniform measurement error standard deviation of σε = 1 basis

point. Also shown are the true simulated shadow-rate path from that sample.

individual distributions across the 1,000 samples. Furthermore, they exhibit the unusual pattern

that their bias and dispersion decline when the quality of the data declines. For the parameters

determined primarily from the cross section, i.e., λ, σ11, σ22, and σ33, we see a reduction of close to

50% in their dispersion when we triple the length of the sample. For the mean parameters, θP2 and

θP3 , we see an even sharper reduction in the dispersion. This is tied to the significant reduction in the

bias of the mean-reversion parameters. However, it is still the case that the near unit-root property

of the level factor is able to cause significant deviations in the estimates of κP21 and θP2 even in these

thirty-year samples.

Finally, Table 7 contains the summary statistics for the mean absolute errors of the filtered

state variables from the individual samples. From the table we infer that the sample length does

not matter for the accuracy of the filtering of the state variables in shadow-rate models estimated

with the extended Kalman filter, and this conclusion is robust to the quality of the data used.

Furthermore, the magnitude of the filtering problems for the extended Kalman filter in the upper

tail of the distribution is slightly exacerbated when the sample length is increased. Thus, neither

higher frequency nor longer samples will solve the filtering problem in the extended Kalman filter

19

Page 21: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

Thirty-year samples, σε = 1 bpParameter

True Mean Std. dev. 5% 1st quartile Median 3rd quartile 95%

κP21

0.1953 0.4190 0.4240 -0.1302 0.1681 0.3510 0.6056 1.1744κP22

0.3138 0.5213 0.2478 0.1809 0.3581 0.4794 0.6434 0.9777κP23

-0.4271 -0.4935 0.2030 -0.8411 -0.6053 -0.4788 -0.3661 -0.1884κP33

0.4915 0.6484 0.2764 0.2508 0.4643 0.6211 0.8053 1.1442

σ11 0.0069 0.0068 0.0002 0.0064 0.0066 0.0068 0.0069 0.0071σ22 0.0112 0.0111 0.0006 0.0102 0.0107 0.0111 0.0115 0.0123σ33 0.0257 0.0258 0.0011 0.0240 0.0250 0.0257 0.0264 0.0275

θP2

0.0014 0.0184 0.4824 -0.0663 -0.0114 0.0157 0.0516 0.1763θP3

-0.0252 -0.0232 0.0641 -0.0409 -0.0287 -0.0216 -0.0150 -0.0033

λ 0.4700 0.4720 0.0039 0.4674 0.4695 0.4714 0.4737 0.4785

σε 0.0010 0.0001 0.0001 0.0000 0.0001 0.0001 0.0001 0.0001

Thirty-year samples, σε = 10 bpsParameter

True Mean Std. dev. 5% 1st quartile Median 3rd quartile 95%

κP21

0.1953 0.2772 0.2695 -0.1314 0.1139 0.2573 0.4154 0.7501κP22

0.3138 0.4578 0.1799 0.2328 0.3384 0.4251 0.5486 0.7821κP23

-0.4271 -0.4723 0.1357 -0.6968 -0.5525 -0.4668 -0.3875 -0.2716κP33

0.4915 0.6355 0.2586 0.3078 0.4531 0.5879 0.7667 1.115

σ11 0.0069 0.0068 0.0005 0.0061 0.0065 0.0068 0.0071 0.0076σ22 0.0112 0.0111 0.0007 0.0100 0.0107 0.0111 0.0115 0.0120σ33 0.0257 0.0258 0.0017 0.0231 0.0248 0.0258 0.0269 0.0285

θP2

0.0014 0.0043 0.0492 -0.0692 -0.0197 0.0029 0.0256 0.0796θP3

-0.0252 -0.0250 0.0100 -0.0420 -0.0312 -0.0249 -0.0181 -0.0092

λ 0.4700 0.4716 0.0139 0.4490 0.4630 0.4717 0.4800 0.4928

σε 0.0010 0.0010 0.0001 0.0010 0.0010 0.0010 0.0010 0.0010

Table 6: Summary Statistics of Estimated Parameters from Simulated Thirty-Year

Monthly Samples of the B-CR Model.

The table reports the summary statistics of the estimation results from N = 1,000 simulated data sets of

the B-CR model, each with a length of thirty years at monthly frequency and a uniform measurement error

standard deviation of σε = 1 basis point and σε = 10 basis points, respectively.

under extreme conditions.

5.4 Analysis of Thirty-Year Weekly Samples

In this section, I analyze the results obtained for the thirty-year weekly samples simulated from the

B-CR model. This simulation exercise maps directly to the U.S. Treasury yield data used in this

paper and analyzed in Christensen and Rudebusch (2015b) and therefore merits special attention.

For this final exercise, Table 8 contains the summary statistics for the 1,000 estimated parameter

sets. First, I note that the finite-sample bias for the mean-reversion parameters is smaller than in

the thirty-year monthly samples and relatively modest in absolute size. Second, it is the case that

the volatility (Σ), mean (θP ), and λ parameters are all estimated without bias in these thirty-year

20

Page 22: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

0 200 400 600 800 1000

−1.

0−

0.5

0.0

0.5

1.0

1.5

2.0

Estimation No.

Par

amet

er e

stm

ate

(a) κP

21.

0 200 400 600 800 1000

0.0

0.5

1.0

1.5

2.0

Estimation No.

Par

amet

er e

stm

ate

(b) κP

22.

0 200 400 600 800 1000

−2.

0−

1.5

−1.

0−

0.5

0.0

Estimation No.

Par

amet

er e

stm

ate

(c) κP

23.

0 200 400 600 800 1000

0.0

0.5

1.0

1.5

2.0

Estimation No.

Par

amet

er e

stm

ate

(d) κP

33.

Figure 8: Estimated Mean-Reversion Parameters from Simulated Thirty-Year Monthly

Samples of the B-CR Model.

Illustration of the estimated mean-reversion parameters in the KP matrix from N = 1,000 simulated data

sets of the B-CR model, each with a length of thirty years sampled monthly and a uniform measurement error

standard deviation of σε = 10 basis points. The true value of each parameter is indicated with a horizontal

solid grey line.

weekly samples independent of the quality of the data. This is very encouraging for the corresponding

estimation results reported in Christensen and Rudebusch (2015b) as they are likely to be free of

bias. Moreover, since these findings are qualitatively on par with the results CLR report based on

forty-year weekly simulations of their Gaussian AFNS model estimated with the standard Kalman

21

Page 23: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

State Mean absolute fitted error, thirty-year samples, σε = 1 bpvariable Mean Std. dev. 5 percentile 1st quartile Median 3rd quartile 95 percentileLt 2.48 1.19 1.75 1.89 2.16 2.62 4.12St 5.28 6.59 1.52 1.73 2.99 5.86 16.93Ct 9.76 7.31 4.80 5.38 7.48 11.09 22.38

State Mean absolute fitted error, thirty-year samples, σε = 10 bpsvariable Mean Std. dev. 5 percentile 1st quartile Median 3rd quartile 95 percentileLt 14.05 2.70 12.01 12.67 13.35 14.42 18.31St 17.17 9.35 11.29 12.19 13.61 18.35 36.34Ct 43.61 12.17 34.16 36.38 39.61 46.09 66.66

Table 7: Summary Statistics of Mean Absolute Fitted Errors of the Filtered State Vari-

ables from Simulated Thirty-Year Monthly Samples of the B-CR Model.

The table reports the summary statistics of the mean absolute fitted error of the three state variables from

N = 1,000 simulated data sets of the preferred AFNS0 model, each with a length of thirty years sampled

monthly and a uniform measurement error standard deviation of σε = 1 basis point and σε = 10 basis points,

respectively. All numbers are measured in basis points.

filter, I conclude that for the sample length and frequency analyzed here the extended Kalman filter

delivers fully satisfactory results that appear to be able to match those a fully efficient estimator

would produce.

To end the section, Table 9 contains the summary statistics for the mean absolute errors of the

filtered state variables from the individual samples. We see the same pattern as observed for the

ten-year samples, namely that increasing the sampling frequency does improve filtering accuracy and

by about the same magnitude as we observed in the switch between ten-year monthly and weekly

samples. Hence, it continues to be the case that sample length matters little for filtering accuracy

in shadow-rate models estimated with the extended Kalman filter. Also, the filtering errors in the

problematic samples in the upper tail of the distribution are of a similar magnitude as in the ten-year

samples.

6 Conclusion

In this paper, I perform a series of carefully orchestrated simulation exercises to study the efficiency

of the extended Kalman filter in estimating the established Gaussian shadow-rate model analyzed in

Christensen and Rudebusch (2015b).

Based on the results I make the following notable observations. First, parameters determined

primarily from the cross section (Σ,λ) are estimated without bias based on the extended Kalman

filter. Second, the finite-sample bias for parameters determined primarily from the times-series

dimension (KP and θP ) appears to be no more severe than in Gaussian models where the standard

Kalman filter is an efficient and consistent estimator. Third, filtering of the state variables is only

22

Page 24: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

Thirty-year samples, σε = 1 bpParameter

True Mean Std. dev. 5% 1st quartile Median 3rd quartile 95%

κP21

0.1953 0.2882 0.2582 -0.0819 0.1284 0.2682 0.4121 0.7263κP22

0.3138 0.4521 0.1667 0.2369 0.3340 0.4223 0.5482 0.7696κP23

-0.4271 -0.4701 0.1223 -0.6777 -0.5466 -0.4637 -0.391 -0.2702κP33

0.4915 0.6365 0.2359 0.3251 0.4680 0.5962 0.7657 1.0985

σ11 0.0069 0.0069 0.0001 0.0067 0.0068 0.0069 0.0069 0.0070σ22 0.0112 0.0112 0.0002 0.0109 0.0111 0.0112 0.0114 0.0116σ33 0.0257 0.0258 0.0005 0.0251 0.0255 0.0258 0.0261 0.0265

θP2

0.0014 0.0076 0.0508 -0.0588 -0.0172 0.0053 0.0304 0.0783θP3

-0.0252 -0.0244 0.0096 -0.0406 -0.0305 -0.0245 -0.0178 -0.0092

λ 0.4700 0.4703 0.0012 0.4686 0.4696 0.4703 0.4710 0.4721

σε 0.0001 0.0001 0.0001 0.0000 0.0001 0.0001 0.0001 0.0001

Thirty-year samples, σε = 10 bpsParameter

True Mean Std. dev. 5% 1st quartile Median 3rd quartile 95%

κP21

0.1953 0.2527 0.2389 -0.0938 0.1127 0.2354 0.3823 0.6619κP22

0.3138 0.4391 0.1613 0.2379 0.3268 0.4077 0.5250 0.7353κP23

-0.4271 -0.4702 0.1191 -0.6737 -0.5505 -0.4658 -0.3909 -0.2761κP33

0.4915 0.6356 0.2448 0.3144 0.4589 0.5893 0.7591 1.1083

σ11 0.0069 0.0068 0.0003 0.0064 0.0066 0.0068 0.0070 0.0073σ22 0.0112 0.0112 0.0004 0.0105 0.0110 0.0112 0.0114 0.0118σ33 0.0257 0.0258 0.0010 0.0241 0.0252 0.0258 0.0264 0.0274

θP2

0.0014 0.0019 0.0452 -0.0625 -0.0224 0.0001 0.0237 0.0709θP3

-0.0252 -0.0249 0.0098 -0.0421 -0.0310 -0.0247 -0.018 -0.0094

λ 0.4700 0.4706 0.0068 0.4597 0.4664 0.4705 0.4750 0.4809

σε 0.0010 0.0010 0.0000 0.0010 0.0010 0.0010 0.0010 0.0010

Table 8: Summary Statistics of Estimated Parameters from Simulated Thirty-Year

Weekly Samples of the B-CR Model.

The table reports the summary statistics of the estimation results from N = 1,000 simulated data sets of

the B-CR model, each with a length of thirty years at weekly frequency and a uniform measurement error

standard deviation of σε = 1 basis point and σε = 10 basis points, respectively.

unsatisfactory when yields are unusually low and very compressed against the zero lower bound, a

phenomenon only really observed in Japanese yield data.

Based on these observations I recommend using the extended Kalman filter to estimate U.S.

shadow-rate models, but question its use for estimation of Japanese shadow-rate models where inter-

est rates have experienced the kind of severe prolonged compression near the zero lower bound that

I find can cause the extended Kalman filter significant difficulty.

A key remaining question is whether other nonlinear filtering techniques would be able to over-

come the problems encountered with the extended Kalman filter in the exercises in this paper. And if

so, what the tradeoffs are in terms of other aspects of the estimation performance and computational

challenges. These are all questions left for future research.

23

Page 25: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

State Mean absolute fitted error, thirty-year samples, σε = 1 bpvariable Mean Std. dev. 5 percentile 1st quartile Median 3rd quartile 95 percentileLt 2.13 0.92 1.72 1.77 1.88 2.12 3.17St 3.41 4.44 1.50 1.57 1.92 3.17 10.86Ct 7.35 5.23 4.73 4.94 5.65 7.53 15.04

State Mean absolute fitted error, thirty-year samples, σε = 10 bpsvariable Mean Std. dev. 5 percentile 1st quartile Median 3rd quartile 95 percentileLt 10.58 1.95 9.29 9.67 10.04 10.78 13.72St 13.37 7.22 9.25 9.65 10.58 13.79 26.95Ct 33.93 9.94 27.28 28.51 30.23 35.35 51.92

Table 9: Summary Statistics of Mean Absolute Fitted Errors of the Filtered State Vari-

ables from Simulated Thirty-Year Weekly Samples of the B-CR Model.

The table reports the summary statistics of the mean absolute fitted error of the three state variables from

the N = 1,000 simulated data sets of the preferred AFNS0 model, each with a length of thirty years sampled

weekly and a uniform measurement error standard deviation of σε = 1 basis point and σε = 10 basis points,

respectively. All numbers are measured in basis points.

References

Bauer, Michael D., Glenn D. Rudebusch, and Jing (Cynthia) Wu, 2012, “Correcting Estimation

Bias in Dynamic Term Structure Models,” Journal of Business and Economic Statistics, Vol.

30, No. 3, 454-467.

Black, Fisher, 1995, “Interest Rates as Options,” Journal of Finance, Vol. 50, No. 7, 1371-1376.

Christensen, Jens H. E., Francis X. Diebold, and Glenn D. Rudebusch, 2011, “The Affine Arbitrage-

Free Class of Nelson-Siegel Term Structure Models,” Journal of Econometrics, Vol. 164, No.

1, 4-20.

Christensen, Jens H. E., Jose A. Lopez, and Glenn D. Rudebusch, 2015a, “A Probability-Based

Stress Test of Federal Reserve Assets and Income,” Journal of Monetary Economics, Vol. 73,

26-43.

Christensen, Jens H. E., Jose A. Lopez, and Glenn D. Rudebusch, 2015b, “How Efficient is the

Kalman Filter at Estimating Affine Term Structure Models?,” Manuscript, Federal Reserve

Bank of San Francisco.

Christensen, Jens H. E. and Glenn D. Rudebusch, 2012, “The Response of Interest Rates to U.S.

and U.K. Quantitative Easing,” Economic Journal, Vol. 122, F385-F414.

Christensen, Jens H. E. and Glenn D. Rudebusch, 2015a, “Estimating Shadow-Rate Term Structure

Models with Near-Zero Yields,” Journal of Financial Econometrics, Vol. 13, No. 2, 226-259.

24

Page 26: How Efficient is the Extended Kalman Filter at Estimating ... · the cross section of yields are sensitive to sample length, data quality, and sampling frequency. ... I recommend

Christensen, Jens H. E. and Glenn D. Rudebusch, 2015b, “Modeling Yields at the Zero Lower

Bound: Are Shadow Rates the Solution?,” Advances in Econometrics, Vol. 35, forthcoming.

Duffee, Gregory R., 1999, “Estimating the Price of Default Risk,” Review of Financial Studies, Vol.

12, No. 1, 197-226.

Duffee, Gregory R., 2002, “Term Premia and Interest Rate Forecasts in Affine Models,” Journal of

Finance, Vol. 57, No. 1, 405-443.

Fisher, Mark and Christian Gilles, 1996, “Term Premia in Exponential-Affine Models of the Term

Structure,” Manuscript, Board of Governors of the Federal Reserve System.

Kim, Don H. and Kenneth J. Singleton, 2012, “Term Structure Models and the Zero Bound: An

Empirical Investigation of Japanese Yields,” Journal of Econometrics, Vol. 170, No. 1, 32-49.

Krippner, Leo, 2013, “A Tractable Framework for Zero Lower Bound Gaussian Term Structure

Models,” Discussion Paper 2013-02, Reserve Bank of New Zealand.

Nelson, Charles R. and Andrew F. Siegel, 1987, “Parsimonious Modeling of Yield Curves,” Journal

of Business, Vol. 60, No. 4, 473-489.

Thompson, Samuel, 2008, “Identifying Term Structure Volatility from the LIBOR-Swap Curve,”

Review of Financial Studies, Vol. 21, No. 2, 819-854.

25