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Demographics and The Behaviour of Interest Rates
By Carlo A. Favero, Arie E. Gozluklu, Haoxi Yang

In this paper we relate the very persistent component of interest rates to a specific demographic variable, MYt, the proportion of middle-aged to young population. We first reconsider the results in Fama (2006) to document how MYt captures the long run component identified by Fama in his analysis of the one-year spot rate. Using MYt to model this low frequency component of interest rates is particularly useful for forecasting the term structure as the demographic variable is exogenous and highly predictable, even at very long horizons. We then study the forecasting performance of a no-arbitrage affine term structure model that allows for the presence of a persistent component driven by demographics. This performance is superior to that of a traditional affine term structure model with macroeconomic factors (e.g. Ang, Dong and Piazzesi, 2005).

J.E.L. CLASSIFICATION NUMBERS: C33, C53, E43, E44
Keywords: demographics, affine term-strucutre models, forecasting

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Last updated April 20, 2011