Author : Kyu Ho Kang(Korea University), Byung Soo Koo(Bank of Korea)

<Abstract>

In this paper, we introduce and estimate a novel five-factor affine term structure model with trends. This model is designed to incorporate the gradual structural changes in the level and slope (term spread) of the yield curve in South Korea. Specifically, the model extracts level, slope, and curvature factors from yield curve data, then decomposes the level and slope factors into stochastic trends and cyclical components in order to reflect gradual structural changes. The results demonstrate that the five-factor model exhibits superior performance in terms of statistical criteria when compared to existing affine term structure models. The principal findings can be summarized in three key points. First, while the cyclical components account for a larger proportion of interest rate fluctuations for shorter maturities, for longer maturities, the proportion of the trend components increases. Secondly, the five-factor model provides an adequate explanation of the trend movement of the market's long-run expectations for the policy rate, which takes account of long-term growth and inflation. Thirdly, the model allows for the extraction of market expectations across different maturities from the estimation of the term premium, thereby providing a variety of methodologies for the analysis of market participants' expectations for policy rates. The model presented in this study, which incorporates gradual structural changes, offers relatively stable results even in the face of financial and economic shocks, thereby making it particularly useful for central banks.