Estimation of Peru’s sovereign yield curve: the role of macroeconomic and latent factors

Purpose Following Ang and Piazzesi (2003), we use an Affine Term Structure model to study the relevance of macroeconomic (domestic and foreign) factors for Peru’s sovereign yield curve in the period from November 2005 to December 2015. Design/methodology/approach Risk premia are modeled as time-varying and depend on both observable and unobservable factors; and we estimate a Vector Autoregressive (VAR) model considering no-arbitrage assumptions. Findings We find evidence that macro factors help to improve the fit of the model and explain a substantial amount of variation in bond yields. However, their influence is very sensitive to the specification model. Variance decompositions show that macro factors explain a significant share of the movements at the short and middle segments of the yield curve (up to 50%), while unobservable factors are the main drivers for most of the movements at the long end of the yield curve (up to 80%). Furthermore, we find that international markets are relevant for the determination of the risk premium in the short term. Higher uncertainty in international markets increases bond yields, although this effect vanishes quickly. Finally, we find that no-arbitrage restrictions with the incorporation of macro factors improve forecasts. Originality/value To our knowledge this is the first application of this type of models using data from an emerging country such as Peru.