Correcting Estimation Bias in Dynamic Term Structure Models

The affine dynamic term structure model (DTSM) is the canonical empirical finance representation of the yield curve. However, the possibility that DTSM estimates may be distorted by small-sample bias has been largely ignored. We show that conventional estimates of DTSMcoefficients are indeed severely biased, andthis bias results in misleading estimates of expected future short-term interest rates and of long-maturity term premia. We provide a variety of bias-corrected estimates of affine DTSMs, both for maximallyflexible and over-identified specifications. Our estimates imply short rate expectations and term premia that are more plausible from a macro-finance perspective.