Application of Kalman Filter on modelling interest rates

This study aims to test the feasibility of using a data set of 90-day bank bill forward rates from the Australian market to predict spot interest rates. To achieve this goal I utilized the application of Kalman lter in a state space model with time-varying state variable. It is documented that in the case of short-term interest rates,the state space model yields robust predictive power. In addition, this predictive power of implied forward rate is heavily impacted by the existence of a time-varying risk premium in the term structure.

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