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A tale of two yield curves: Modeling the joint term structure of dollar and euro interest rates

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  • Egorov, Alexei V.
  • Li, Haitao
  • Ng, David
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Abstract

Modeling the joint term structure of interest rates in the United States and the European Union, the two largest economies in the world, is extremely important in international finance. In this article, we provide both theoretical and empirical analysis of multi-factor joint affine term structure models (ATSM) for dollar and euro interest rates. In particular, we provide a systematic classification of multi-factor joint ATSM similar to that of Dai and Singleton (2000). A principal component analysis of daily dollar and euro interest rates reveals four factors in the data. We estimate four-factor joint ATSM using the approximate maximum likelihood method of (Aït-Sahalia, 2002) and (Aït-Sahalia, forthcoming) and compare the in-sample and out-of-sample performances of these models using some of the latest nonparametric methods. We find that a new four-factor model with two common and two local factors captures the joint term structure dynamics in the US and the EU reasonably well.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Econometrics.

Volume (Year): 162 (2011)
Issue (Month): 1 (May)
Pages: 55-70

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Handle: RePEc:eee:econom:v:162:y:2011:i:1:p:55-70

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Web page: http://www.elsevier.com/locate/jeconom

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Keywords: Affine term structure models International term structure models Approximate maximum likelihood LIBOR Euribor Specification analysis of term structure of interest rates Out-of-sample model evaluation;

References

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  1. Tauchen, George E. & Gallant, A. Ronald, 1995. "Which Moments to Match," Working Papers, Duke University, Department of Economics 95-20, Duke University, Department of Economics.
  2. Egorov, Alexei V. & Li, Haitao & Xu, Yuewu, 2003. "Maximum likelihood estimation of time-inhomogeneous diffusions," Journal of Econometrics, Elsevier, Elsevier, vol. 114(1), pages 107-139, May.
  3. Andrew Ang & Monika Piazzesi & Min Wei, 2003. "What does the yield curve tell us about GDP growth?," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Mar.
  4. Georg Mosburger & Paul Schneider, 2005. "Modelling International Bond Markets with Affine Term Structure Models," Finance, EconWPA 0509003, EconWPA.
  5. Yacine Aït-Sahalia & Robert Kimmel, 2002. "Estimating Affine Multifactor Term Structure Models Using Closed-Form Likelihood Expansions," NBER Technical Working Papers 0286, National Bureau of Economic Research, Inc.
  6. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 55(5), pages 1943-1978, October.
  7. Estrella, Arturo & Hardouvelis, Gikas A, 1991. " The Term Structure as a Predictor of Real Economic Activity," Journal of Finance, American Finance Association, vol. 46(2), pages 555-76, June.
  8. Ahn, Dong-Hyun, 2004. "Common Factors and Local Factors: Implications for Term Structures and Exchange Rates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(01), pages 69-102, March.
  9. Frederic S. Mishkin, 1988. "What Does the Term Structure Tell Us About Future Inflation?," NBER Working Papers 2626, National Bureau of Economic Research, Inc.
  10. Egorov, Alexei V. & Hong, Yongmiao & Li, Haitao, 2006. "Validating forecasts of the joint probability density of bond yields: Can affine models beat random walk?," Journal of Econometrics, Elsevier, Elsevier, vol. 135(1-2), pages 255-284.
  11. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc.
  12. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
  13. Singleton, Kenneth J., 2001. "Estimation of affine asset pricing models using the empirical characteristic function," Journal of Econometrics, Elsevier, Elsevier, vol. 102(1), pages 111-141, May.
  14. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 88(5), pages 829-53, October.
  15. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, vol. 56(1), pages 279-304, 02.
  16. Inci, Ahmet Can & Lu, Biao, 2004. "Exchange rates and interest rates: can term structure models explain currency movements?," Journal of Economic Dynamics and Control, Elsevier, vol. 28(8), pages 1595-1624, June.
  17. Michael J. Brennan & Yihong Xia, 2006. "International Capital Markets and Foreign Exchange Risk," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 753-795.
  18. Hodrick, Robert & Vassalou, Maria, 2002. "Do we need multi-country models to explain exchange rate and interest rate and bond return dynamics?," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1275-1299, July.
  19. Brandt, Michael W. & Santa-Clara, Pedro, 2002. "Simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets," Journal of Financial Economics, Elsevier, Elsevier, vol. 63(2), pages 161-210, February.
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Citations

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Cited by:
  1. Joao Frois Caldeira & Guilherme Valle Moura & Marcelo Savino Portugal, 2011. "Efficient Interest Ratecurve Estimation And Forecasting In Brazil," Anais do XXXVII Encontro Nacional de Economia [Proceedings of the 37th Brazilian Economics Meeting] 133, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].
  2. Peter C. B. Phillips & Jun Yu, 2008. "Simulation-based Estimation of Contingent-claims Prices," Finance Working Papers 22473, East Asian Bureau of Economic Research.
  3. Gregory H. Bauer & Antonio Diez de los Rios, 2012. "An International Dynamic Term Structure Model with Economic Restrictions and Unspanned Risks," Working Papers 12-5, Bank of Canada.
  4. Cheridito, Patrick & Filipovic, Damir & Kimmel, Robert L., 2006. "Affine Term Structure Models," Working Paper Series 2007-2, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  5. Seungmoon Choi, 2011. "Closed-Form Likelihood Expansions for Multivariate Time-Inhomogeneous Diffusions," School of Economics Working Papers 2011-26, University of Adelaide, School of Economics.
  6. Yacine Aït-Sahalia & Robert Kimmel, 2002. "Estimating Affine Multifactor Term Structure Models Using Closed-Form Likelihood Expansions," NBER Technical Working Papers 0286, National Bureau of Economic Research, Inc.
  7. Choi, Seungmoon, 2013. "Closed-form likelihood expansions for multivariate time-inhomogeneous diffusions," Journal of Econometrics, Elsevier, Elsevier, vol. 174(2), pages 45-65.

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