An application of generalized Vasicek term structure models to the UK gilt-edged market: a Kalman filtering analysis

Oneand two-factor models of the term structure of interest rates analysed by Babbs and Nowman are applied to the UK gilt-edged market. The two factors are identified with shortand long-term economic ‘news’ streams which may be correlated and effect the yield curve. Examples of short-term economic ‘news’ may include ‘rumours’ of interest rate decisions from the new Monetary Policy Committee of the Bank of England and long-term ‘news’ may include monthly and quarterly economic statistics. The model is expressed in a state space form and the Kalman filter is used to estimate the unobserved state variables and the parameters of the model. The state space formulation has the advantages of taking into account both the cross-sectional and time-series restrictions on the data and measurement errors in the observed yield curve. Estimates are obtained using United Kingdom data obtained from the Bank of England’s new approach to estimating the yield curve over the period 1982—1996 and empirical results support the need for a two-factor model.