Yield Curve Modeling
The yield curve and interest rate levels are difficult to forecast in aggregate or individually. Forecasting accuracy is improved when focusing on the factors (level, slope, and curvature) that describe the term structure and augmenting the models with a market or economic variable. Their combination shows that
deviations from the modeled yield curve may provide opportunity.
Nelson and Siegel (1987) researched a model to determine the appropriate
long-term interest rate, which used three factors to describe the term structure of interest rates (yield curve): the level, slope, and curvature. They added two decay variables for the slope and curve that are analogs to duration, a measure of bond interest rate sensitivity. Their model used interest rates up to the 10-year term to accurately describe the level of the 20 and 30-year interest rates.