Time Varying Coefficient Models; A Proposal for selecting the Coefficient Driver Sets

Coefficient drivers are observable variables that feed into time-varying coefficients (TVCs) and explain at least part of their movement. To implement the TVC approach, the drivers are split into two subsets, one of which is correlated with the bias-free coefficient that we want to estimate and the other of which is correlated with the misspecification in the model. This split, however, can appear to be arbitrary. We provide a way of splitting the drivers that takes account of any nonlinearity that may be in the data, with the aim of removing the arbitrary element in driver selection. We also provide an example of the practical use of our method by applying it to modeling the effect of ratings on sovereign-bond spreads.