Liquidity and Yield Curve Estimation

This paper examines the effect of incorporating liquidity into the Nelson-Siegel-Svensson model from the perspective of out-of-sample forecasting ability and trading performance. The liquidity consideration reduces the distortion from concentrated trading activities and significantly increases the forecasting ability of the dynamic curve-fitting model. Taking liquidity into account can improve the risk-adjusted returns of a trading strategy developed from the forecasting error series. The improvement in the forecasting ability and the trading performance is consistent across different sets of parameter values and different bond issues, and it becomes more substantial when the forecasting period expands.