Giving Flexibility to the Nelson-Siegel Class of Term Structure Models

his paper compares the interpolation abilities of nonparametric and parametric term structure models which are widely used by the main Central Banks of the world. Seeking the combination of smoothness and flexibility, a new Nelson-Siegel class model is introduced. It emerges as an extension of the Svensson (1994) and the five factor model proposed by De Rezende and Ferreira (2008) and Christensen, Diebold and Rudebusch (2008). It is shown the superiority of the smoothing spline model in interpolating the spot and forward rates as well as the advantage of the proposed model over the other Nelson-Siegel models. The superiority of the smoothing spline, however, comes with a cost: its instability in fitting the initial vertices of the term structure. The proposed model, on the other hand, exhibits the desirable properties of smoothness and flexibility, especially for the forward rates and the spot rates of medium and long terms.