Decomposition of Term Structure of Interest Rates in Brazil

1 Introduction

In this study, we aim to replicate the methodology proposed by Adrien, Crump, and Moench (2013) in the context of the Brazilian interest term structure. Adrien et al. (2013) developed a comprehensive framework for analyzing interest rate expectations and volatility, which has been widely used in financial research. By adapting their methodology to the Brazilian market, we seek to provide valuable insights into the dynamics of the country’s interest rates and yield curve.

The methodology proposed by Adrien, Crump, and Moench (2013) offers a robust approach to modeling interest rate expectations by extracting information from a variety of financial instruments. By incorporating data from Brazilian interest rate futures, we can construct a comprehensive picture of the Brazilian interest term structure. This allows us to estimate market participants’ expectations of future interest rates and assess the associated uncertainty.

As a key emerging market economy, Brazil exhibits distinct characteristics that influence interest rate dynamics, including inflation expectations, monetary policy decisions, and global market trends. By replicating the methodology of Adrien, Crump, and Moench (2013) for the Brazilian interest term structure, we seek to shed light on how market participants perceive and anticipate changes in interest rates, as well as the implications for financial market outcomes and economic policy.

2 Methodology

The study proposes an innovative regression-based approach to interest rate pricing, they introduce a three-step ordinary least squares (OLS) estimator that leverages observable pricing factors. By decomposing pricing factors into predictable components and innovatively estimating market price of risk parameters, they offer a methodological alternative that sidesteps assumptions about serial correlation in yield pricing errors, addressing limitations in prior approaches suggested by Joslin, Singleton, Zhu (2011) and Hamilton, Wu (2012). Moreover, our analytical standard errors account for regressor uncertainty, making our approach robust and reliable for pricing interest rates.

In the empirical analysis, they present a detailed specification featuring five principal components of zero coupon yields as pricing factors, demonstrating the significance of model complexity in accurately capturing term premium dynamics. Notably, our model showcases minimal pricing errors and absence of autocorrelation in return pricing errors, indicating its robustness and suitability for real-world applications. Additionally, they introduce a four-factor specification following Cochrane, Piazzesi (2008), which reveals the nuanced relationships between pricing factors and term premium dynamics. By conducting rigorous specification tests and out-of-sample exercises comparing the five-factor model to the four-factor alternative, they establish the superior performance and predictive accuracy of our preferred specification, highlighting its potential for practical application in financial analysis.

3 Empirical Results

(under revision)