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What does a term structure model imply about very long-term interest rates?

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  • Balter, Anne G.
  • Pelsser, Antoon
  • Schotman, Peter C.

Abstract

We address two empirical issues related to the long end of the yield curve based on euro swap rates. First, for maturities longer than 20 years we find evidence for an ‘excess’ downward slope that cannot be explained by convexity. Second, volatility at the very long end of the yield curve is larger than predicted by no-arbitrage models. We construct a model-based arbitrage-free extrapolation of the yield-curve and compare it to the regulatory discount curve. Because of near-zero mean reversion, there is no convergence towards an ‘ultimate forward rate’ and convexity effects cause the arbitrage-free extrapolations to have slightly downward sloping curves. The low level of mean-reversion also implies that the volatility of long-term rates does not decline relative to the 20-year volatility. Therefore, we conclude that the mean-reversion and resulting smoothing adopted by the regulatory curve is much too strong.

Suggested Citation

  • Balter, Anne G. & Pelsser, Antoon & Schotman, Peter C., 2021. "What does a term structure model imply about very long-term interest rates?," Journal of Empirical Finance, Elsevier, vol. 62(C), pages 202-219.
    • Handle: RePEc:eee:empfin:v:62:y:2021:i:c:p:202-219
    DOI: 10.1016/j.jempfin.2021.03.006
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    Cited by:

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    2. Thomas A. McWalter & Erik Schlögl & Jacques van Appel, 2023. "Analysing Quantiles in Models of Forward Term Rates," Risks, MDPI, vol. 11(2), pages 1-18, January.

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    More about this item

    Keywords

    Term structure models; Parameter uncertainty; Extrapolation; Insurance supervision;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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