A theoretical foundation for the Nelson and Siegel class of yield curve models

Yield curve models within the popular Nelson and Siegel (hereafter NS) class are shown to arise from a formal low-order Taylor approximation to the generic Gaussian affine term structure model. That theoretical foundation provides an assurance that NS models correspond to a well-accepted framework for yield curve modeling. It further suggests that any yield curve from the GATSM class should be parsimoniously representable by an two-factor arbitrage-free NS model, which should prove useful for macrofinance applications. Such a model is derived and applied to provide evidence for changes in United States yield curve dynamics pre- and post-1988.