An Extension of the Five-factor Affine Term Structure Model: Predicting Future Bond Returns*

Abstract

We investigate time-varying risk premia in Korean government bonds using a five-factor affine model. The model generates nearly perfectly fitted yields and estimates the bonds' expected returns with more precision than the four-factor model. We also find the statistically significant predictive power of the model for future bond returns using forward rates from cross-sectional and time-series regressions. The predictive power varies in time for bonds with different maturities and reverts to the mean values for short- and long-term bonds, while showing a sign of momentum for medium-term bonds. In out-of-sample exercises, the predictive power is even enhanced when volatility increases.