CPR Working Paper Series No. 96

A widely relied upon but a formally untested consideration is the issue of stability in factors underlying the term structure of interest rates. In testing for stability, practitioners as well as academics have employed ad-hoc techniques such as splitting the sample into a few sub-periods and determining whether the factor loadings have appeared to be similar over all sub-periods. Various authors have found mixed evidence on stability in the factors. In this paper we develop a formal testing procedure to evaluate the factor structure stability of the US zero coupon yield term structure. We find the factor structure of level to be unstable over the sample period considered. The slope and curvature factor structures are however found to be stable. Common structural changes affecting all interest rate maturities have fostered instability in the level factor. We corroborate the literature that variances (volatility) explained by the level, slope, and curvature factors are unstable over time. We find that the volatility of slope factor is sensitive to shocks affecting the short rates and the volatility of curvature factor is sensitive to shocks affecting the medium and long rates. Finally, we find evidence of the presence of common economic shocks affecting the level and slope factors, unlike slope and curvature factors that responded differently to economic shocks and were unaffected by any common instabilities.