The Structure of Spot Rates and Immunization

Authors

  • EDWIN J. ELTON,

  • MARTIN J. GRUBER,

  • RONI MICHAELY

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    • Stern School of Business, New York University. Elton and Gruber are Nomura Professors of Finance. We would like to thank Chris Blake, Ernest Bloch, Linda Canina, William Greene, and Bruce Tuckman for their helpful comments.

ABSTRACT

Empirical studies of the modern theories of bond pricing typically choose proxies for the state variables in a rather arbitrary fashion. This paper empirically analyzes the question of the optimal spot rates to use as state variables. Our findings indicate that the four-year spot rate serves as the best proxy in the one-state-variable model. In the case of the two-state-variables model, the six-year rate and eight-month rate are identified as best. Tests of the out-of-sample prediction ability indicate that our model is superior to Macaulay's duration model and alternative proxies for state variables.

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