Joint dynamics of Brazilian interest rate yields and macro variables under a no-arbitrage restriction

This work combines macroeconomic factors and an arbitrage-free model of bond yields to explain the behavior of dollar interest rate contracts traded in Brazil. We relax restrictions that macroeconomic and latent variables are independent of each other and of the policy interest rate. The results show that the Ang and Piazzesi (Ang & Piazzesi, 2003) model is more accurate than the random walking model and provides a good forecast of the interest rate sign changes when we consider conditional dependence among latent and macroeconomic variables.

► We combine macroeconomic factors and an arbitrage-free model of bond yields to explain the behavior of dollar interest rates traded in Brazil.
► We relax Ang and Piazzesi's restriction that macroeconomic and latent variables are independent of each other and of the policy interest rate.
► When we compare the statistics of the root mean squared prediction error metric, the Ang and Piazzesi model produce the lowest mean and median, but a higher standard deviation and maximum.
► The modified Ang and Piazzesi model provides a better forecast of the signs of interest rate changes.