An Alternative Approach for Determining the Time-Varying Decay Parameter of the Nelson-Siegel Model

Abstract

This paper presents an alternative and straightforward two-step estimation method for the Nelson–Siegel yield curve model. The goal is to generate smoothed time series for the time-varying decay parameter and establish stable yield curve factors. To rectify excessive parameter estimates such as jumps or spikes, the decay parameter is adjusted towards its long-run mean using a closed-form expression. Empirical studies conducted with U.S. Treasury data reveal that this method generates stable and easily interpretable outcomes while the confounding effect, which is characterized by large magnitudes with opposite signs among parameters, is effectively mitigated. In out-of-sample forecasting exercises, the proposed model demonstrates comparable or modest performance compared to other competing models, including the random walk model. In particular, the shifting endpoints technique enhances the overall forecasting ability. Finally, the proposed model demonstrates an effective smoothing effect robustly even when applied to other countries.